Valuation process is a part of the investment decision process in which the value of an asset is estimated. Research asserts that the two main approaches to the valuation process are (1) the top-down, three-step approach and (2) the bottom-up, stock-picking approach. Although both approaches may be equally used by advocates of fundamental and technical analysis, they differ in the way each one perceives the importance of the economy and industry in the valuation of a firm.
The top-down, three-step valuation approach holds that, regardless of the qualities or capabilities of a firm and its management, the economic and industry environment has a major impact on the success of a firm and the rate of return on its stocks. To illustrate this, we assume that an investor owns the stocks of a viable and successful firm. If the shares are owned during an economic expansion, the sales and the earnings of the firm will increase thus increasing the returns the investor receives 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, in order to estimate the future value of a security and its rate of return it is absolutely essential to analyze the outlook for the aggregate economy and the industry that the firm operates in. Investors, who use this approach, forecast which industry can outperform the market by analyzing the broader environment and they choose specific firms to invest in.
The bottom-up, stock-picking approach overlooks economic conditions and industry potential and focuses on a firm’s individual attributes. Investors, who use bottom-up approach, study primarily a firm’s fundamentals such as sales and earnings figures, balance sheet and cash flow statement. Balance sheet reflects managerial effectiveness and wise allocation of capital. Strong cash flows depict a firm which is able to finance its operations without raising additional debt. In addition, studying the potential market size is also required when investors use the bottom-up valuation approach. Although market size cannot be estimated accurately, still weighing its potential provides a good projection of the earnings potential a firm can achieve. Besides, information about a firm’s market share is also required, because the bottom-up valuation approach asserts that successful firms consistently increase their market share and expand into new markets with solid growth prospects. Therefore, if fundamentals make sense and the firm is strong, the business cycle or broader industry conditions are not considered.
The top-down, three-step valuation process is supported by academic studies, which assert that economic environment has a significant effect on firm’s earnings and that there is a relationship between stock prices and economic expansions and contractions. Moreover, the changes in individual stock returns are explained by changes in the rates of return of the firm’s industry. On the other hand, the bottom-up valuation process is challenged as it requires superior stock-picking skills in order to identify undervalued stocks. In addition, the psychological factors and cognitive biases of investors can lead markets off-center.
Conclusively, the top-down, three-step valuation approach is preferable valuation approach because it is not subject to subjective preferences and plain figures. By considering the aggregate economy and market, examining global industries and analyzing individual firms, it determines the value of a security based on market consensus rather than on the individual traits of investors.