The value of a financial asset is primarily subject to its quality and profit potential. However, the economic environment and the industry performance are equally influential to the value of a security and its rate of return.

The top-down, three-step valuation approach holds that both the economy/market and the industry effect have a significant impact on the total returns for individual securities. To illustrate this, we assume that an investor owns the stocks of a viable and successful firm. If the shares are owned during an economic expansion, the sales and the earnings of the firm will increase thus increasing the returns the investor receives from owning the firm’s stocks. However, if the stocks are owned during an economic recession, the sales and the earnings of the firm will decline and consequently the stock price will decline as well. Therefore, in order to estimate the future value of a security and its rate of return it is absolutely essential to analyze the outlook for the aggregate economy and the industry that the firm operates in.

In the following pages, the paper analyzes the three steps in the valuation process which involve (1) the influence of the economic environment on the firms, (2) the importance of the industry environment on the firms and (3) the fundamentals of individual firms.

Economic Environment

The economic environment is mainly driven by fiscal and monetary measures which influence the aggregate economy of a country and consequently all the industries and firms within the economy.

Fiscal policy influences the direction of an economy through changes in government taxes or fiscal allowances. For example, imposing additional taxes on income, liquor, cigarettes, and gasoline can discourage consumer spending, while increases in government spending on unemployment insurance can offer financial relief. Fiscal policies influence the business environment particularly for firms that rely on such expenditures. At the same time, we should consider that government spending has a strong multiplier effect. For example, if road building is increased, then the demand for concrete materials will increase. Consequently, the profitability of construction firms will increase.

Monetary policy influences the direction of an economy through measures that control the supply of money, the cost of money and the interest rates of the economy. For example, a restrictive monetary that targets to reduce the growth rate of the money supply, it can reduce the supply of funds for working capital and expansion of the economy. Similarly, a restrictive monetary policy that targets the interest rates, it will increase firms’ costs and will make money more expensive for consumers.