Stock Valuation Methods

There are two main methods of stock valuation. Below is the discussion of the two stock valuation method and their differences.

Top down stock valuation method

The top down stock valuation method is a three stage stock valuation method involving analysis of:

• the stock market (economic influences and stock market analysis factors)
• the industry sector (indutry factors), and
• companies within the industry sector (individual company analysis)

Bottom up stock valuation method

The bottom up stock valuation method is the stock picking method where individual stocks are identified.

What are the differences between the two stock valuation methods?

The difference between the two stock valuation methods lies in their view of predominant factors affecting their returns. The top down stock valuation method is based on the idea that economy, market and industry effects account for a significant proportion of individual stock returns. The bottom up stock valuation method argues that it is impossible to identify undervalued stocks that will outperform regardless of the market or industry outlook.

Which stock valuation method is the best?

There are supporters of both stock valuation methods. However, the top down stock valuation method is more popular and deemed better than the bottom up stock valuation method because stock picking ignores important information about the market and the industry as follows:

• Most changes in companies' earnings can be explained by changes in aggregate corporate earnings (more important) and industry earnings.
• There is a relationship between aggregate stock prices and unemployment, income and production economic series.
• Changes in rates of return for individual stocks can largely be attributed to changes in rates of return for the stock market and the industry.