Investors typically select investments that provide a rate of return, which compensates them for their time, the expected rate of inflation and the risk involved. In this context, the value of an investment is estimated based on the required rate of return, which is calculated using either the top-down, three-step approach or the bottom-up, stock-picking approach. This paper investigates and compares the top-down and the bottom-up valuation approaches in relation to the investment decision process. Both approaches are used to estimate the rate of return and may be equally used by advocates of fundamental and technical analysis. However, the paper concludes that the top-down, three-step valuation approach is preferable because it considers the aggregate economy and market, it examines global industries and it analyzes individual firms in order to determine the value of the stock.
Keywords: valuation process, top-down valuation approach, bottom-up valuation approach
[...] Estimating future stream of cash flows A cash flow stream is a finite set of payments that an investor will receive or invest over time. The present value of the cash flow stream is equal to the sum of the present value of each of the individual cash flows in the stream. n PV = Σ [CFt / t=0 where: PV = the Present Value of the Cash Flow Stream CFt = the cash flow which occurs at the end of year t r = the discount rate t = the year, which ranges from zero to n n = the last year in which a cash flow occurs. [...]
[...] On the other hand, the bottom-up valuation process is challenged by research studies, which assert that it requires superior stock-picking skills in order to identify undervalued stocks among so many stocks that trade around the globe (Mikhail, Walther, Wang & Willis, 2006). The reason is because a lot of the information provided about stocks is not measurable and therefore it cannot be evaluated. Managerial effectiveness is reflected in a firm's fundamentals, i.e. the quantifiable aspects of firm. However, investors need to get information on a firm's qualitative aspects as well, such as competitive advantage, and employee performance, in order to assess if a firm can remain viable in the future. [...]
[...] Finally, 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 Top-Down or Bottom-Up Valuation Process? After having analyzed the features of top-down, three-step and bottom-up, stock-picking valuation approach, the paper focuses on a comparison of the two processes in order to conclude which serves the investment decision process more effectively. The three-step valuation process is broadly analyzed by academic studies. [...]
[...] 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 (MacKay & Phillips, 2005). 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. [...]
[...] If the estimated intrinsic value is lower than the market price, then investors should sell the security or do not buy it if they do not already own it The top-down, three step valuation approach The value of a financial asset is primarily subject to its quality and profit potential. However, the economic environment and the industry performance are equally influential to the value of a security and its rate of return. The top-down, three-step valuation approach holds that both the economy/market and the industry effect have a significant impact on the total returns for individual securities. [...]
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