Bond valuation is a simple process compared to stock analysis.  The value of stock is the value of the firm itself.  A share of stock is simply a portion of the value of the firm.  All shares combined equal the firm's total value.  The term VALUATION to accountants, financiers, and business leaders is a difficult term to quantify.  Land, for example, on a firm's balance sheet can be valued by making an appraisal.  However, even if an appraisal is done, will all appraisers agree on its price?  Probably not.  If we take that same example and extend it over the entire firm, its assets, holdings, investments, product, and most importantly, its earnings (and earnings potential), we may being to see how many opinions may be formed about the firm, its value and its anticipated future value.

To begin the Top Down valuation process, it is necessary to being with Economic Analysis.  If we can envision an inverted pyramid with three sections; the first section (from the top) holds economic variables used to measure the health of the economy.  The center section hold industry variables.  The bottom section, the smallest section of the pyramid, holds valuation variables of the individual firm.

Economic Analysis:  Business Cycles, Monetary & Fiscal Policy, Economic Indicators, World Events & Foreign Trade, Inflation, Public Sentiment, GDP Growth, Unemployment, Productivity, Capacity Utilization, etc.

Industry Analysis:  Industry Structure, Competition, Supply-Demand Relationships, Product Quality, Cost Elements, Government Regulation, Business Cycle Exposure, etc.

Analysis of the Individual Firm:  Forecasts of Earnings, Dividends and discount rates, Balance Sheet/Income Statement Analysis, Management,
Research, Return, Risk, etc

This logical progression is used by most analysts to make value judgments on company value.  The analyst would begin at the top of the pyramid, assess the economic climate from an investment perspective, select an industry that would best perform in the current economy, then select individual firms within that industry that would make the best investments.

One of our assignments uses the Value Line Investment Survey.  Value Line holds a great reputation for investment research and information.  They use this Top Down approach (no surprise).  We will see this as we use this assignment.

[ A Bottom-Up approach is the opposite of Top-Down.  Those engaging in Bottom-Up investment analysis are many times called "Stock Pickers" because they begin with a stock then investigate the industry of that stock, then assess weather the economy is favoring that industry. Or they do no analysis at all, meaning that they were privy to a "hot stock" tip from a friend]

Actual article mentioning top-down and bottom-up analysis including company earnings and a market forecast:  CLICK HERE.

Business Cycle of Economic Activity:  The business cycle is usually a graph of economic activity.  The graph shown below would have all of the characteristics of a typical business cycle:  Peaks, troughs, periods of expansion, periods of reduced economic activity.  This interest rate graph of 6-month T-Bill rates is a good example of how the economy's activity is tracked.

This is a graph of the typical Industry Life Cycle. 

When an industry is young, it is in the Introduction or Development Stage, sales or profits are not strong but developing.

Ideally, the industry, if at all successful, will expand at a rate superior to the over-all economy.  We all want investment that are in the Growth & Expansion phase, the steep portion of the graph.  How many of us dreamed of being one of the few who invested in Microsoft, Dell, Wal-Mart, Home Depot, etc., from the start of the firm's life!

As an industry matures, it's profits (sales) level off.  The firm is not expected to grow faster than the over-all economy.  At this point, the mature firm is making money and not expanding like the growth phase.  Investors (owners) expect the firm to begin paying dividends.  The auto industry is a great example of an industry in maturity.  Their plants are built, they change the manufacturing process for each model year and continue making their product.  The auto industry is also an example of an industry that makes durable goods - those goods are designed to last for more than a year.  A durable goods
industry is one that performs poorly in a recession.  It is not a "recession resistant" industry.  What would a consumer stop buying if they felt their job was unstable?  Durable goods.  They would not commit to big purchases if they did not have to.  They would wait for the bad economic times to pass, then perhaps update the "big ticket" items like cars.  A recession resistant industry would be food, pet food, etc.  Where bad economic times barely alter our purchases of these items.  When a recession is coming, many professional money managers sell out of industries that fare poorly and buy into industries that survive recessions.

We will discuss the subject of dividend paying stocks very completely in class.  The act of a firm paying dividends is a signal to investors that they are (1) not able to reinvest the money into the firm profitably; (2) they are beyond Phase B; (3) the amount of the dividend is "usually equal to the percentage return of a savings account."  A very important figure.

In some cases, an industry may face a decline in sales beyond their peak.  Picking on the auto industry again, the US auto makers are facing smaller and smaller market share, they are losing sales to foreign auto makers like Toyota.  In 2004, Ford slipped from its number 2 spot in the world market to number three, behind Toyota. (GM is still number 1, for now)