Top Down vs. Bottom Up: 2 very different ways to select an action

In stock assessment you can choose two paths from top to bottom or from bottom to top. I propose that you explore in this note the benefits for a retail investor to consider the benefits of the method called “top-down” for the analysis of actions, contraposition to the reverse method, the “bottom-up”.

Each of the processes begins in a different way, so it has different methodologies:

• The process of TOP-DOWN Evaluation First of all, the most general aspects, i.e. the environment or the investment framework that part of the macroeconomic and conjunctural aspects worldwide, then examine the macroeconomic and financial aspects at the country level, and then examine the situation in the economic activity sector in which it is located. It ends in the analysis of the company in particular, i.e. macroeconomic aspects, its financial ratios and valuation.
• On the contrary, BOTTOM-UP type evaluation process, part of the most specific aspects of a signature, is defined, firstly, the company which is selected separately by its principals and ends in an analysis of more general aspects, but which will not focus on the final decision, but will be the microeconomic aspects that will prevail. Only after passing this important filter is analyzed the industry that belongs to the company to know the opportunities and threats. It then goes on to review the national economy and the international economy, to find out if there is any variable that can influence our decision.

The levels of international interest rates are very important, because the interest rate rises (as is taking place since the beginning of 2022) causes low stock prices (and vice versa) because the discount rate of future fund flows increases and consequently decreases the present value of the shares, which moves to the market with a low price of that action to arbitrate the new scenario. General rule, it makes sense to buy actions when interest rates drop: if a lower discount rate is taken, the present value will increase. In addition, financial costs and margins are an appreciable area in the expenses of any company, so lower interest rates involve lower costs and expected net profit increases, which should boost the price of its action.

Regional aspects also have their own weight in the evolution of quotes, especially for companies that are very dependent on integration with neighbouring countries. This is the case with the evolution of the macroeconomic indicators of the other countries of the European Economic Union for the Eurozone, or for companies that market in a customs union, such as Argentina and Mercosur Brazil.

The importance of domestic macroeconomic aspects is undoubtedly greater than it is believed to be: the economic situation of a country influences the microeconomics of its companies, as well as the situation is reflected in it. The vast majority of them over the Internet and in free and free form.

Since we know what country to invest in, that is, we have made the decision to, for example, invest in Brazil's growth as an emerging market and as a member of the BRIC country group with good fundamentals, we will define in what sectors to invest in. For this reason, we will have to look at the conjuncture of them, that is, in which sectors I strategically want to be positioned.

In order to do so, an in-depth analysis of the sectors, whether regulated or not, benefit from a more competitive exchange rate or not, if it has implicit risks to its specific activity or not, its profitability margins, whether it is a cyclical or not, and constantly continue its evolution (change in laws and regulations, changes in technology, etc.)

The last step is usually defined as the stock-picking: it is the analysis and selection of the best signatures of that country and that sector by its fundamentals, i.e. the specific risk and return characteristics of a company. The valuation of company price analysts is generally based on financial flow discount methods. Here one should basically design future cash flows, analyze the possible operational growth pattern, as well as the discount rate employed depending on the selected asset, which has lower or higher risk for the investor. The flow of funds expected for a defined period of years (typically for the next 10 years) should be projected and, hence, lower, evaluating this cash flow in the form of a perpetuity, taking into account also the macro and sectoral estimates that have already been studied in the previous two steps. The estimated values must then be deducted at the appropriate rate to find the intrinsic value of an asset or its fair value, the value it should have. If the market price differs from the latter, a decision is taken: to buy (if it is smaller) or to sell the asset (if it is larger).

Since the analyst has a degree of knowledge of the macroeconomic environment, both international and domestic, it has to start looking at the sector in which it develops. The sectoral indicators, in addition to a current diagnosis, serve to design the trends of the sector in which signature is played: conjuncture, structure (market size, barriers to entry, regulatory framework, competitiveness, etc.), opportunities for new investments, growth, etc. Competition plays a leading role in the analysis of sectoral factors, since comparable companies offer a range of ratios which constitute a reference point for the analysis of a subscription. The structure and composition of the sector and the market are vital data to estimate the company's fund flows under analysis.

An estimate of demand (i.e. the level of billing or sales measured in the legal course currency) and the supply of the sector (i.e. the level of activity or production of enterprises measured in physical units). The evolution of product prices and the estimation of current and historical market prices, consensus estimates or other specialized sources, or, in the case of companies selling a mix of diversified products, an average price based on a projection of the sales mix both by products (greater or lower aggregate value) and by markets (internal or exports).

The aspects related to the available credit make the capital structure of the sector and its degree of financial leverage, i.e. its net debt/patrimony ratio. The higher the available credit and the lower its cost, the greater the feasibility of profitable investment projects. The existence of many long-term obligations (high debt) can be a bad sign, and if they are in the short term, worse.

Finally, the microeconomic aspects of the company should be analyzed in itself, which are the starting point of the bottom up method. The company's profitability, cost analysis, margins, which EBITDA generates its main activity, operational cash flow generation, financial activity and financial leverage, as well as its coverage ratio, ongoing and projected investments, product quality.

After detecting that the company meets all the requirements to be incorporated into the portfolio, it should be evaluated whether it is cheap or expensive, because an attractive company by its bases, sometimes it is not a good investment because everything is already discounted in its prices or is expensive based on traditional methods of devaluation, especially by multiple relative devaluation. The determination of the target price is part of this analysis to be able to draw a conclusion that has practical application: buy or not buy, sell if you already have or keep it in your wallet.

The current or past situation of a company does not take so much into account, but especially its ability to generate benefits in the future. The stock market values expectations and confirms every day with real data. In other words, the periodic publication of profits in companies and their comparison with past profits and other companies in the sector are a basic data for the investor, in addition to any other fact relevant to that company and to the others.

In short, the top-down analysis or bottom-up analysis are two different ways to help us make the decision on how to invest in the action of a company. In the first method, one is faced with an analysis that starts from the macro (global) and descends to the micro (specific), i.e., they will define themselves the large components of the system to, little by little, go down made more specific or small variables, and vice versa for the second method.