AN INTRODUCTION TO SECURITY VALUATION
Answers to Questions
The top-down valuation process begins by examining the influence of the general
economy on all firms and the security markets. The next step is to analyze the various
industries in light of the economic environment. The final step is to select and analyze the
individual firms within the superior industries and the common stocks of these firms.
The top-down approach thus assumes that the first two steps (economy-market and
industry) have a significant influence on the individual firm and its stock (the third step).
In contrast, the bottom-up approach assumes that it is possible to select investments (i.e.
firms) without considering the aggregate market and industry influences.
It is intuitively logical that aggregate market analysis precede industry and company
analysis because the government and federal agencies can exert influence on the
aggregate economy via fiscal (changes in government spending, taxes, etc.) and monetary
(changing money supply, interest rates, etc.) policy. Further, inflation, another aggregate
economic variable, must be considered because of its major impact on interest rates and
the spending and saving/investment of consumers and corporations. Therefore, a major
division is the asset allocation among countries based upon the differential economic
outlook including exchange rates (the outlook for the currency).
Again, industry analysis should precede individual security analysis since there are
several factors that are generally national in scope but have a pervasive effect on some
industries - e.g., industry-wide strikes, import/ export quotas, etc. In addition, alternative
industries feel the impact of economic change at different points in the business cycle
-e.g., industries may lead or lag an expansion. Further, some industries are cyclical (e.g.,
steel, auto), some are stable (utilities, food chains, etc.).
The thrust of the argument is that very few, if any, industries perform well in a recession,
and a “good” company in a “poor” industry may be difficult to find.
All industries would not react identically to changes in the economy simply because of
the different nature of business. The auto industry for instance tends to do much better
than the economy during expansions but also tends to do far worse during contractions as
consumers’ consumption patterns change. In contrast, the earnings of utilities undergo
modest changes during either expansion or recession since they serve a necessity and thus
their sales are somewhat immune to fluctuations. Also, some industries “lead” the
economy while others only react late in the cycle (e.g., construction).