The investment decision process should be very similar to the shopping process you follow for goods and services, such as clothes, or electronics. While shopping for any product, you try to evaluate how much that product is worth to you, is it good value for money, and are there comparable items that sell below that item’s price. If the price for the item is below or equal to your valuation of its worth, you buy it. That worth is the intrinsic value of the asset.
Buying a stock or any kind of asset should be similar. If the asset is priced by the market below its worth, it is a good buy. The valuation of the asset’s worth is called its intrinsic value. If you already own the asset, and the asset is now priced by market at a price higher than its intrinsic value, you may consider selling the asset. Of course, you have to consider trading costs, taxes, and personal constraints before making any decision.
There are two general approaches of arriving at the intrinsic value of an asset. First is a top-down, three-step approach, and the second one is a bottom-up approach.
In the three-step top-down approach, one analyzes the economy, followed by the industry, and finally the individual asset to arrive at an intrinsic value. On the other hand, the bottom-up approach analyzes the stock in isolation from the economy and industry. Each approach has its advocates and critics. Although you can be successful with both approaches, I think that the bottom-up approach misses out on important signals of the top-down approach. The prospects of a company depend on the economy along with the innate characteristics of the company. A shoe company, for example, can have great management, great products, and high consumer demand. The moment the economy is in a recession, the prospects of the company, and the industry the company operates in, start to look bleak.
Pictorially, the top-down process can be described as below.
The first step in the process is economic analysis. This includes an analysis of the monetary and fiscal policy of the country in which a company operates or derives a significant share of its revenue. A restrictive monetary policy will weigh on a company’s earnings in the short run. For example, a central bank deciding to increase interest rates will make borrowing more expensive and difficult and could stall profitable projects for a company. Similarly, a restrictive fiscal policy, such as an increase in tax rates, can discourage company spending. In addition, it’s important to consider the economic health of the country. Is the country at a risk of war, are there any new tariffs on goods, is currency going to be devalued, and is there any political uncertainty? – all these questions, and more, need to be analyzed.
Next step in industry analysis. Companies operating in the food industry, for example, will not be affected much by a recession. There will always be demand for food staples. However, retail industry will fare better in an economic expansion, as consumer spending is higher during those times.
Finally, company analysis will tell you if the stock is worth the money. In this step, you will analyze numbers, ratios and values to come up with your best estimate of the intrinsic value. You would then compare the current trading price of the company’s stock to this intrinsic value to make an investment decision.
If Intrinsic value > Current Price, Buy
If Intrinsic value < Current Price, Sell
You should also consider your transaction costs and taxes in the above decision process.
Here’s a link to stock market basics.