Summary: The top-down, three-step valuation approach is a commonly used valuation method because it analyzes the relationship between rates of return, industry performance and corporate earnings, showing that most of the changes in individual stock returns are explained by changes in the rates of return.
Defining the top-down, three step valuation approach
The top-down, three-step valuation approach suggests that the total returns of an individual security are highly influenced by the aggregate economy and the industry that the firm operates. To illustrate this, we assume that you own the stocks of a viable and profitable firm. If the shares are owned during an economic expansion, the sales and the earnings of the firm will increase and so will the returns you will receive from owning the firm's stocks. However, if the stocks are owned during an economic recession, the sales and the earnings of the firm will decline and consequently the stock price will decline as well. Therefore, if you want to estimate the future value of your securities and the individual rates of return, you have to analyze both the outlook of the economy and the prospects of the industry that the firm operates in.
In particular, the steps to follow when considering the top-down, three-step valuation approach are the following:
Economic Environment
The economic environment is mainly driven by fiscal and monetary measures which influence the aggregate economy of a country and consequently all the industries and firms within the economy.
Fiscal policy influences the direction of an economy through changes in government taxes or fiscal allowances. For instance, imposing additional taxes on income, liquor, cigarettes, and gasoline can discourage consumer spending, while increases in government spending on unemployment insurance can offer financial relief. Fiscal policies influence the business environment particularly for firms that rely on such expenditures. At the same time, we should consider that government spending has a strong multiplier effect. For instance, if road building is increased, the demand for concrete materials will increase and the profitability of construction firms will increase.
Monetary policy influences the direction of an economy through measures that control the supply of money, the cost of money and the interest rates of the economy. For instance, a restrictive monetary policy that targets to reduce the growth rate of the money supply can reduce the supply of funds for working capital and expansion of the economy. Similarly, a restrictive monetary policy that targets the interest rates can increase the costs of a firm and make money more expensive for consumers.
Other factors that affect the economic environment are inflation, political turmoil, international monetary devaluations and terrorist attacks.
Industry Environment
Industry analysis is important because it determines a firm's business risk based on sales volatility and operating leverage. In competitive industries, a firm's position and financial leverage is subject to the competitive moves of other firms in the industry, but also to the status of the firm as entrant, serving, or exiting firm.
Economic trends affect industry performance. Industry performance is related to the stage of the business cycle. Different industries react differently to economic changes at different stages of the business cycle. Therefore, industry analysis takes into consideration the stage of the business cycle that a firm is when the analysis takes places.
Industries are classified into cyclical and non-cyclical. Cyclical industries (steel, autos) perform better when the aggregate economy expands and suffer when the aggregate economy contracts. Non-cyclical industries (retail food) are stable during recession, but they do not experience a significant growth during expansion. Investors should examine if the firm belongs to a cyclical or non-cyclical industry in order to make the optimal investment decision at the right time.
Another important consideration when analyzing the industry environment is the risk that international companies undertake when doing business in foreign markets. Firms that sell their products/services in international markets can benefit or suffer from shifts in the foreign economies. For instance, the fast-food industry (McDonalds, Burger King) often experiences low demand in the domestic market and growing demand in the international market.
Company Analysis
After having forecasted the industries that can possibly outperform the market, you should choose specific firms based on their performance as reflected in their fundamentals. Financial ratios and cash flow values are significant only when compared to industry averages.
Company analysis aims at identifying the best firm in the promising industry. Before investing you need to examine historical data and project your estimates for future performance. After having determined the firm's value, you should compare the estimated intrinsic value to the market price to make the optimal investment decision. The goal is to identify the undervalued stocks in the promising industry and to include them in your portfolio based on their correlation to the other financial assets in the portfolio (bonds, mutual funds and cash). However, to make sure that these stocks are undervalued, you have to be relatively certain that the firm will be profitable in the future. Otherwise, these securities cannot be considered undervalued today if the estimated intrinsic value is not potentially higher.
The top-down, three-step valuation approach is a commonly used valuation method because it analyzes the relationship between rates of return, industry performance and corporate earnings, showing that most of the changes in individual stock returns are explained by changes in the rates of return. Although, over time the importance of market effect declines and the industry effect varies among industries, the combined market-industry effect on a stock's rate of return is significant.
Also, effective investment decision making requires primarily effective allocation of assets in the portfolio, which can be achieved only if investors are aware of the broader environment a firm operates in. Asset allocation guides investors in regards to (1) the ideal geographical allocation (2) the ideal industry allocation and (3) the ideal portfolio allocation i.e. proportion that each class of asset (stocks, bonds, mutual funds and cash) should contribute to the portfolio.
Sources
Cavaglia, S., Brightman C., Aked, M. (2000). The Increasing Importance of Industry Factors. Financial Analysts Journal, September/October 2000, Vol. 56, No. 5: pp. 41-54
Cohen A.J. (1996). Economic Forecasts and the Asset Allocation Decision. Economic Analysis for Investment Professionals, AIMR, Charlottesville, November 1996
MacKay, P, Phillips G.M. (2005). How Does Industry Affect Firm Financial Structure? The Review of Financial Studies, Oxford Journals
