The Valuation Handbook: Valuation Techniques from Today's Top Practitioners

CHAPTER 1

Two Frameworks for Understanding Valuation Models

 

Benton E. Gup

Chair of Banking University of Alabama

 

 

There is a saying that if you don’t know what to look for, you are not going to see it. That is especially true for readers of this book who have a limited background in finance and investments. This chapter provides two concepts that will help put the valuation models and concepts presented in this book in context. The two concepts are top-down/bottom-up analysis and the life cycle.¹

TOP-DOWN/BOTTOM-UP ANALYSIS

The traditional approach to analyzing investments is commonly called fundamental analysis. That approach is represented in Exhibit 1.1 as the top-down analysis of securities. The basic idea of top-down analysis is to start with a company, such as Microsoft, and then examine the major factors that affect the firm now and are likely to affect it in the future. This includes but is not limited to information about the economic outlook, legislation that may affect the company, industry information, demographics, and other factors that may be important when estimating a firm’s growth potential. Then analyze the firm and determine its intrinsic value. Intrinsic va lue is the theoretical value of a security, and it may differ from the market price. The simplified dividend valuation model is one method of determining intrinsic value, and it is shown here in equation (1.1). The equation states that the price of a stock is equal to expected dividends discounted ...