Here we will focus on the application of discounted cash flow techniques in equity valuation. while valuing equities it is important to remember that the cash flows are not contractually agreed so we need to adjust for the uncertainty of cash flows with a discount factor that includes an appropriate risk premium. There are two general approaches to the valuation process which can be used by both fundamental and technical analysts.
This is also called the three-step approach. This approach is based on the belief that the return from investing in a stock is heavily dependent on which economy, market and industry the issuer is in. Analysis using a top-down approach follows the steps shown below.
1. Analyze alternative economies and securities markets
The objective is to decide the country allocation and the allocation among bonds, equities and cash in each market. Analysts of economies will study a government’s fiscal and monetary policies, inflation, interest rates, corporate and consumer expenditure, and exchange rates. Other macro factors include international events such as wars and political changes.
Generally, if a country is expected to move into recession, equity investors would tend to under weigh a market (relative to its weight based on market value) and focus on defensive investments. On the other hand, if the economic outlook is positive, they will tend to overweigh a market.
2. Analyze alternative industries
The next step is to use economic and market analysis to decide which industries will benefit and which will suffer in the expected environment. Other factors to consider are issues such as demographics and the industry’s international exposure. These factors will determine which industries should be overweighed and which should be under weighed relative to the market weightings.
Industry analysis is an important step; it is very difficult for a company to perform well if it is operating in an industry that faces difficulties and all companies’ profitability will be affected by their industry environment.
3. Analyze individual companies and securities
Individual companies are analyzed within the industries selected. This will include analyzing each company’s past performance and forecasting its future prospects and then determining its value. Once the value has been compared to the market price you can decide whether it is an attractive investment.
The top-down method is preferred by the authors due to its logical process and empirical support. It has been shown that stock prices and a company’ earnings are linked to the economic environment and that the rates of return for industries and stocks within the industry are linked.
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