The valuation of securities should consider a firm’s economic and industry environment during the valuation process. Regardless of the qualities or capabilities of a firm and its management, the economic and industry environment will have a major influence on the success of a firm and the realized rate of return on its stock.
General Economic Influences
The first step in business valuation process is the general economic influences. Monetary and fiscal policy measures enacted by various agencies of national governments influence the aggregate economies of those countries, The resulting economic conditions influence all industries and companies within the economies.
Fiscal policy initiatives, such as tax credits or tax cuts, can encourage spending, whereas additional taxes on income, gasoline, cigarettes, and liquor can discourage spending. Increases or decreases in government spending on defense, on unemployment insurance or retaining programs, or on highways also influence the general economy. All All such policies influence the business environment for firms that rely directly on such government expenditures
Monetary policy produces similar economic changes. A restrictive monetary policy that reduces the growth rate of the money supply reduces the supply of s for working capital and expansion for all businesses. Alternatively, a restrictive monetary policy that targets interest rates would raise market interest rates and therefore firms’ costs and make it more expensive for individuals to finance home mortgages and the purchase of other durable goods, such as autos and appliances. Monetary policy therefore affects all segments of an economy and that economy’s relationship with other economies.
The second step in the valuation process is to identify global industries that will prosper or suffer in the long run or during the expected near-term economic environment, Examples of conditions that affect specific industries are strikes within a major producing country, import or export quotas or taxes, a worldwide shortage or an excess supply of a resource, or government-imposed regulations on an industry.
It is important to know that different industries react to economic changes at different points in the business cycle. For example, firms typically increase capital expenditures when they are operating at full capacity at the peak of the economic cycle. Therefore, industries that produce plant and equipment will typically be affected toward the end of a cycle. In addition, alternative industries have different responses ti0 the business cycle.
After determining that an industry’s outlook is good, an investor can analyze and compare individual firms’ performance within the entire industry using financial ratios and cash flow values. Many financial ratios for firms are valid only when they are compared to the performance of their industries.
You undertake company analysis to identify the best company in a promising industry. This involves examining a firm’s past performance, but more important, its future prospects. After you understand the firm and its outlook, you can determine its value using one of several valuation models.
The final step is to select the best stock or bonds within a desirable industry and include it in your portfolio based on its relationship (correlation) with all other assets in your portfolio. The best stock for investment purposes may not necessarily be issued by the best company because the stock of the finest company in an industry may be overpriced, which would cause it to be a poor investment. You cannot know whether a security is undervalued or overvalued until you have analyzed the company, estimated its intrinsic value, and compared your estimated intrinsic value to the market price of the firm’s stock.