In last week’s article, we looked at how the top-down approach is used by investors who use fundamental analysis to determine which shares to invest in. In this week’s article, we will look at the opposing approach known as the bottom-up approach which is also used by fundamental analysts.
The bottom-up approach is a strategy that involves analysing individual companies to determine whether they are worth investing in. This approach is based on the idea that a company’s share price is determined by its fundamental factors such as earnings, revenues, and growth potential.
In contrast to the top-down approach, which involves analysing the overall economic and market conditions, the bottom-up approach focuses on individual companies’ intrinsic value. The bottom-up approach is a popular strategy among value investors who seek to invest in companies that are undervalued by the market.
Steps to Implement the Bottom-Up Approach.
Step 1: Identify Potential Investment Opportunities
The first step in the bottom-up approach is to identify a potential investment opportunity. This involves conducting research to identify companies that have a strong financial performance and growth potential. This may for example happens when investment analysts are made aware that a company may have a good product in the market or have a competitive advantage. This can put such a company on the analyst’s radar as a possible good investment.
Step 2: Analyse the Company’s Financial Statements
Once a potential investment opportunity has been identified, the next step is to analyse the company’s financial statements. This involves examining the company’s balance sheet, income statement, and cash flow statement to determine its financial health.
Investors pay close attention to key financial metrics such as revenue growth, profitability, debt levels, and cash flow. These metrics can provide insight into the company’s financial performance and its ability to generate future cash flow and reinvest in the business.
Step 3: Assess the Company’s Management Team
In addition to analysing the company’s financial statements, analysists will also assess the company’s management team. This involves evaluating the CEO’s track record, their vision for the company, and their ability to execute on their strategy.
As part of this step, it is also important to consider the company’s corporate governance practices, such as the independence of the board of directors, the structure of executive compensation, and the company’s approach to risk management. All of this will give investment analysts a sense of how the company operates and if there are any growth opportunities worth investing in.
Step 4: Consider the Company’s Competitive Advantages
Another important factor to consider when analysing individual companies is their competitive advantages. This includes factors such as the company’s brand, intellectual property, patents, and distribution network. Companies that have strong competitive advantages may be able to maintain market share and generate sustainable profits over the long term.
Step 5: Determine the Company’s Valuation
Once the company’s financial performance, management team, and competitive advantages have been assessed, the final step in the bottom-up approach is to determine the company’s valuation. This involves comparing the company’s current share price to its intrinsic value. Intrinsic value is a financial term used to describe the true or inherent value of an asset or investment. The goal is to identify whether the company may be worth more based on the valuations which is then compared to what it is trading for on an exchange.
Investors can use various valuation methods, such as the discounted cash flow (DCF) analysis, price-to-earnings (P/E) ratio, and price-to-book (P/B) ratio, to determine a company’s intrinsic value.
If the company’s current share price is below its intrinsic value, it may be a good investment opportunity as they believe the share price will increase to match their valuation. However, if the share price is above its intrinsic value, the company may be overvalued, and investors may want to consider other investment opportunities.
The bottom-up approach is a popular strategy for investors who seek to invest in individual companies based on their fundamentals. Investors usually use a combination of the bottom-up and top-down approach when identifying which shares to include in their portfolio. These investment strategies can be thought of as an organised and systemic approach investors use to analyse lots of information and data. In next week’s article, we will take a closer look at some popular valuation metrics used by investors to complete our discussion on fundamental analysis.
