Bottom-up analysis is a way to analyze a system in granular detail, from its smallest components up, which means that this type of analysis is usually very detailed. It can reveal the root causes of any given problem by looking at the actual cause instead of simply trying to find solutions that try to prevent or reduce symptoms.
The term “bottom-up” refers to causing something from its foundation upwards based on an understanding of how it works based on its component parts. Bottom-Up analysis takes all pertinent data into account and looks holistically at the issue by examining different aspects of it within an information context – also known as System Theory – so as to be able to identify causal relationships accordingly.
Bottom-up Analysis in Finance Strategy
Bottom-up analysis in the field of finance strategy is a method of finding opportunities for financial gain by looking at individual, small components within an industry. This type of analysis is designed to work on the premise that there are large opportunities for profit through discovering and exploiting mispriced securities or other market inefficiencies.
Bottom-up analysis differs from top-down analysis in that it starts at the ground level and focuses on smaller components which lead to macro factors. A bottom-up approach often incorporates a variety of different micro approaches such as: earnings models, sales forecasts, and cash flow projections.
How to Conduct a Bottom-up analysis
Bottom-up analysis begins by taking the cash flow statements for each project and dividing them into the income statement portion, which shows total sales or total expenses, as well as into income statement items such as operating activities or expense items such as sales expenses. It then takes the cash flow statements for each item of revenue or expense and evaluates that item of revenue or expense’s contribution to net profit. When determining the value of each element in a cash flow statement for valuation purposes it is required that all elements are valued using consistent principles.
This method is consistent with recognized accounting standards and it is consistent with recognized valuation principles as well as the rules of computing useful life for depreciation. It is also consistent with the accounting principles that are used to determine how to record a transaction using the matching principle. For those who have been involved in valuing property, you will know that one of the first things that needs to be done is to assign a value or treat each element of cash flow as if it were a separate and distinct investment (which is known as “making investments separately”). The bottom-up analysis can be thought of as making investments separately for each item. This method of analysis can be used to not only value a business, but also to value the individual assets that make up the business.
There are four major steps that need to be considered in conducting bottom-up analysis.
Describing the information to be derived: Bottom-up analysis is a derivation tool. The information to be derived must be described in sufficient detail for the inputs to be found, and the details of the process must be clear. This means that each project or part of a project must have sufficient information on which to base an evaluation.
Determining what data is required: Data needed for bottom-up analysis is similar in many ways to data needed for income statement analysis; it includes sales and expenses, but also all other useful production data such as cost of goods sold and cost of goods overheads (including overheads such as legal costs). It also includes gross margin on sales and expenses on production. It also includes cash flow statement data such as capital spending and financing expenses. In some cases it is required to have the cash flow statement for each item of revenue or expense.
It is important to note that in many ways bottom-up analysis is a review of the information for all revenue and expense items or market segments in a business, with a focus on seeking out any areas that seem out of line relative to others. For example, if most charges are routine charges but one charge is for a major overhaul costing hundreds of thousands of pounds, then that could be an indication that either it’s not a routine charge or that the overhaul cost figure might be incorrect.
Evaluating the contributions: The next step, evaluating the contributions, is where bottom-up analysis begins to become more involved. This is the process where each element of revenue and expense is examined and evaluated against its contribution to net profit and other items such as operating cash flow.
The objective of bottom-up analysis is to determine what elements or market segments should be included in a valuation and what should be excluded. Bottom-up analysis should also be used to evaluate which elements should stay within a business and which elements should be sold off. An investment or asset-oriented evaluation is often carried out after the valuation.
Bottom-up analysis is not intended to be a comprehensive evaluation of all business operations. It is intended to provide a starting point for the valuation, and the focus of the evaluation should be on determining an appropriate starting point, one that can be used to determine other valuation relevant parameters such as book value, tangible book value and fair value.