Distinguish the good eggs from the bad; the key to a good omelet.

When we want to buy or sell stock, the first question that we ask is whether the price of the stock is correct. Let us assume that we are selling NICASIA Bank stock at the market price of Rs 450 per share. How do we know the price is correct? Is it too high or too low? In investment, if the real or true intrinsic price of the stock is too high as compared to market price, it is considered overvalued, and if it is too low, it is considered undervalued.  But how do we calculate the true or real value of the stock so that we can compare it with market price, and decide whether to buy or sell?

There are different methods of calculating the true value of a stock. However, this article is mainly focused on two methods of investment analysis to calculate the true value of a stock: top- down approach, and bottom up approach.

In bottom-up investing, the investors focus their attention on a specific company (i.e. NIC ASIA), rather than on the industry (i.e. banking as whole) in which that company operates or on the economy as a whole. For example, if we want to buy NIC ASIA’s stock, we look at its overall financial health, i.e. past performance, financial statements, products and services, other individual indicators of performance over time like management and organizational structure etc. If we are satisfied with its past performance, and management efficiency, we may decide to invest, if not, we may not buy the stock.  Bottom-up investment analysis does not focus on economic cycles, status of overall banking industry, but instead aims to find the best companies and stocks regardless of economic, market or particular industry macro trends. This approach assumes individual companies can do well even in an industry that is not performing. For example, if banking industry in Nepal is not performing very well due to the liquidity crisis, but based on our bottom up analysis, if we are confident that NIC ASIA can perform better in the future, we may decide to buy the stock.

In top-down investment analysis, we emphasizes economic, market and industrial trends before making a more granular investment decision to allocate capital to specific companies. For example, let’s assume that we want to buy stocks of a company but we are not sure which sector (i.e. hydro, banking, insurance, and hotel) is performing better. Therefore, the first step is to analyze the sectors and then choose that sector which we believe will perform better in the future. Once we decided the sector, then we select a best stock within the chosen sector to invest. For example, let’s assume that based on macro economy, Nepal Rastra Bank’s regulation, and others, we find that banking sector is most likely to perform better in the future.  Therefore, we decided to invest in the banking sector. The second step is to choose stock/company within the banking sector for our investment. Now within the banking sector, we could potentially identify NICASIA as a good company to invest based on its past performance and other indicators.

The premise behind bottom-up investing is a focus on the quality of individual stocks and their ability to generate returns,

Which analysis is better?

We need to understand that there is no right and wrong approach. Both approaches have their own merits and demerits. Top-down approach is backward-looking, while bottom-up approach is forward-looking. Top-down investing involves analyzing the "big picture." Investors using this approach look at the economy and try to forecast which industry will generate the best returns. Let’s take an example of Nepali banking sector. Nepal Rastra Bank has made it mandatory for all “A” class commercial banks to increase their paid up capital to Rs. 8 Billion. As a result, the whole banking sector is affected due to this regulatory requirement and people rushed to buy shares of “A” class commercial bank in anticipation of right shares and bonus shares. Conversely, a bottom-up investor overlooks broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company. Investors who believe in the bottom-up approach simply seek strong companies with good prospects, regardless of industry or macroeconomic factors. Investment planning can rely on both top-down and bottom-up approaches. The purpose of both approaches is the same, which is to identify which stocks to buy. Bottom-up investing is the approach that many “average” investors are likely to feel most comfortable with as it is most conducive to longer-term outlook.  The premise behind bottom-up investing is a focus on the quality of individual stocks and their ability to generate returns, rather than focusing on an entire industry or the impact of business and market cycles. However, the approach that we choose depends on our specific investment style, objectives, liquidity, risk attitude, time horizon, and our expertise. If only one of these approaches was vastly superior to the other, then it is likely that only one would still exist.