Top-Down Investment Approach:
It is the investment approach that starts with analyzing macroeconomic factors & outlook of a country, post shortlisting countries the next step is to identify & analyze industry-specific impacts & lastly shortlist the companies based on the overall macro & industry-specific view.
Bottom-Up Investment Approach:
It is the investment approach that starts with analyzing company fundamentals analysis i.e analysis of income statement, balance sheet & cashflow, etc. Post company analysis the next step is industry analysis & macroeconomic factors & outlook of a country, It is the reverse step of the Top-Down Investment approach.
Both methods are extremely useful based on different circumstances. In the case of global equities being available at a deep discount due to any worldwide factor risk, the ideal way is a bottom-up investment approach. Macroeconomic strength is extremely important for making any sort of investment.
The most popular macroeconomic data points investors analyze are:
a. GDP growth rate outlook: The GDP growth rate gauges the health of the economy. When the figure is positive, the economy is expanding. When the number is negative, it indicates that the economy is contracting.
b. Inflation outlook: Inflation is the rate at which prices rise over a given time period. Inflation is typically defined as a broad measure, such as the overall increase in prices or the cost of living in a country. Lower inflation is better for equity investments.
c. Interest rate outlook: An interest rate tells you how much it costs to borrow money or how much it pays to save money. So, the company is a borrower, the interest rate is the amount the company pays for borrowing money, expressed as a percentage of the total loan amount. A lower interest rate is better for equity investment.
d. Currency Appreciation/Depreciation in a global context: Increase in the value of a domestic currency, reduces the import bill for importing countries & companies, whereas depreciation increases the export revenue for exporting countries & companies. Both processes have an impact on domestic inflation.
e. Global Commodities Supply & Demand outlook: Global commodities pricing has a direct impact on the company's raw material inflation. Hence, a shortage of supply & excessive demand leads to an increase in pricing or a contraction of the company's margin.
f. Geopolitical Risk: Equity investment performance are highly sensitive to Geopolitical Risk. An adverse development leads to a risk-aversion sentiment among investors.
h. Working Population/ Skilled Labours availability: The shortage of skilled laborers/ working population has a direct impact on the GDP growth rate. Hence, the working population growth rate leads to more productivity and expansion of the economy.
The most popular industry-specific factors investors analyze are:
a. Five Competitive Forces:
1. Threat of New Entrants: It is the risk that a new competitor poses to existing companies in an industry. This happens when a new company starts selling the same product or service as an existing company.
2. Bargaining Power of Suppliers: It refers to the pressure that suppliers can put on businesses by raising prices, lowering quality, or reducing product availability
3. Bargaining Power of Buyers: It refers to the pressure that customers/consumers can put on businesses to get them to provide higher quality products, better customer service, and/or lower prices.
4. Threat of Substitute Products or Services: It refers to the availability of a product that can be purchased by the consumer instead of the industry's product
5. Rivalry among existing competitors: Competitive rivalry is a measure of the extent to which existing firms compete with one another. Intense competition can reduce profits and lead to competitive moves such as price cuts, increased advertising spending, or spending on service/product improvements and innovation.
b. Industry classification:
1. Life Cycle Position: The Industrial Life Cycle
i) Pioneer Stage - Product acceptance is questionable & implementation of business strategy is unclear,
ii) Growth - Product acceptance is established. Roll-out begins and growth accelerates in sales and earnings,
iii) Mature - The industry trend line corresponds to the general economy. Participants compete for a share in a stable industry
iv) Decline - Shifting tastes or technologies have overtaken the industry and demand for its products steadily decreases.
2. Business Cycle: Classification by Business Cycle Behaviour
i) Growth - Above-normal expansion in sales and profits occurs independently of the business cycle
ii) Defensive - Stable performance during both ups & downs of the business cycle
iii) Cyclical - Profitability tracks the business cycle, often in an exaggerated manner
c. External factors:
1. Technology: The survival of a product largely depends on new technology & innovation.
2. Government Policy: The government regulation or policy at times can be very strict or detrimental to the company's growth
3. Social: Social factor boils down to lifestyle and fashion changes or what is currently trending in the market.
4. Demographic: It is the science that studies the vital statistics of the population, such as distribution, age, and income
5. Foreign: Industries are sensitive to foreign influences as global trade expands. For example, global commodities trades like oil, metals, semiconductors, etc.
d. Demand Analysis:
Customer study helps to understand what drives industry revenue. Customer segmentation is important.
e. Supply Analysis:
Supply is a function of unused capacity and the ability to bring on new capacity. If future supply and demand are out of balance, prices for the industry's products will be affected unless the suppliers change their behavior in time.
Product segmentation: Product offerings by brand name, reputation, or services
Degree of industry concentration: Higher Degree of concentration inhibits price movements.
Ease of industry entry: Monopolies promote artificial pricing and industry ease of entry is a key variable in holding prices of the free market model
Price changes in key supply inputs: Certain industries rely heavily on one or two inputs. Price changes in these inputs affect product costs and profitability.
g. International competition and markets:
The world is becoming a smaller place and industries increasingly reflect a globalization theme. This characterization is most advanced in commodity industries such as oil, metals, chemicals, etc. Strong competition from the international market impact the pricing.
The most popular company-specific factors investors analyze are:
a. An overview of the company: including major products/services, current positioning, and history, sales composition, product life-cycle stages, R&D, past and planned capital expenditures, board structure, management analysis, employee benefits, labor relations, insider ownership, legal actions, and other unique strengths and weaknesses.
b. Analyze demand for products/services: sources of demand, product differentiation, past influences, and outlook.
c. Analyze supply for products/services: sources of supply, industry capacity outlook, import/export considerations, and proprietary products or trademarks.
d. Pricing environment: past relationships of demand/supply/prices, significance and outlook for raw material and labor costs, and anticipated future trends.
e. Present and interpret relevant financial ratios: activity ratios, liquidity ratios, solvency ratios, profitability ratios, and financial statistics.
What is Financial Ratio Analysis?
Financial ratio analysis compares the relationship (or ratio) between two or more financial data items from a company's financial statements. It is primarily used to make fair comparisons over time and between different companies or industries.
The following financial ratios are broadly analyzed by the investors:
a. Profitability Ratios: Profitability ratios assist investors in determining the company's profitability. The ratios indicate how well the company can perform in terms of profit generation. A company's profitability also indicates the management's competitiveness. Profitability is an important consideration for a company because it is required for business expansion and to pay dividends to its shareholders.
b. Leverage Ratios: It is also known as solvency ratios or gearing ratios, these ratios assess a company's ability to sustain its day-to-day operations over the long term. Leverage ratios assess the extent to which a company uses debt to fund growth. Remember that the company must pay its bills and obligations in order to continue operations. Solvency ratios assist in understanding the company's long-term viability while keeping its obligations in perspective.
c. Valuation Ratios: The valuation ratios compare the stock price of a company to either its profitability or its overall value to determine how cheap or expensive the stock is trading. As a result, this ratio assists in determining whether the company's current share price is perceived as high or low.
d. Operating Ratios: It is also known as the 'Activity Ratios,' which measure how efficiently a company can convert its assets (both current and noncurrent) into revenues. This ratio enables us to determine how effective the company's management is.
The most popular profitability financial ratios include the following:
The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold:
Gross margin ratio = Gross profit / Net sales
The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency:
Operating margin ratio = Operating income / Net sales
The return on assets ratio measures how efficiently a company is using its assets to generate profit:
Return on assets ratio = Net income / Total assets
The return on equity ratio measures how efficiently a company is using its equity to generate profit:
Return on equity ratio = Net income / Shareholder’s equity
The most popular leverage ratios include the following:
The debt ratio measures the relative amount of a company’s assets that are provided from debt:
Debt ratio = Total liabilities / Total assets
The debt-to-equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity:
Debt to equity ratio = Total liabilities / Shareholder’s equity
The interest coverage ratio shows how easily a company can pay its interest expenses:
Interest coverage ratio = Operating income / Interest expenses
The debt service coverage ratio reveals how easily a company can pay its debt obligations:
Debt service coverage ratio = Operating income / Total debt service
The most popular valuation ratios include the following:
The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders:
Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding
The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:
Dividend yield ratio = Dividend per share / Share price
The earnings per share ratio measures the amount of net income earned for each share outstanding:
Earnings per share ratio = Net earnings / Total shares outstanding
The price-earnings ratio compares a company’s share price to its earnings per share:
Price-earnings ratio = Share Price / Earnings per share
The most popular liquidity ratios include the following:
The current ratio measures a company’s ability to pay off short-term liabilities with current assets:
Current ratio = Current assets / Current liabilities
The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets:
Acid-test ratio = Current assets – Inventories / Current liabilities
The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:
Cash ratio = Cash and Cash equivalents / Current Liabilities
The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period:
Operating cash flow ratio = Operating cash flow / Current liabilities