Top-Down Analysis is a technique that starts from looking at the big picture and identifies what is important, with information being drawn only from the most significant data points. An analyst conducting top-down analysis uses this approach to identify needs for customers or trends in the market. It is widely used by businesses because it helps them prioritize their work without having to research all possible options.
A top-down analysis approach assumes that global (or macroeconomic) trends provide the most important external direction for a firm. The key to making an effective top-down strategy is for this region to be selected or predicted with precision, and the company’s response plan tailored accordingly. Top-down approaches are used in strategic management for identifying key trends and developing competitive strategies (SWOT analysis).
Top-Down analysis in Financial Strategy
Top-Down analysis is a powerful tool for the development and implementation of strategic financial initiatives. It is an analytical perspective that examines the company as a whole and its interdependent relationships with customers, competitors, suppliers, technology partners and other stakeholders.
One can use top-down analysis to identify industry dynamics such as competition, disruptive innovations and market trends before any particular company begins to actively compete in this area. A business strategy can be developed by understanding how it will compete within its broader industry and then designing tactics that fit into these strategic goals.
How to Conduct a Top-Down Analysis
Most people tend to approach the process of conducting a top-down analysis from a bottom-up perspective. In other words, they start with analyzing the firm’s financials and forecast its future profits, then project these figures backwards in time using various valuation models. However, this decision is based on a fundamental misunderstanding of how a top-down approach works.
In contrast to bottom-up analysis, top-down analysis starts with high level assumptions about the macroeconomy and then analyzes what happens in individual firms within that economy. In top-down analysis, we assume beforehand that the world is growing and the economy is expanding. It is followed by an analysis of existing industry structure and determining what would be the industry composition in 50 years under optimistic and pessimistic assumptions about economic growth and productivity. We construct a scenario portfolio of stocks by combining both assumptions: T = topline or E = bottomline. The “bottomline” scenario assumes pessimistic growth assumption while the “topline” scenario assumes optimistic growth assumption. This is usually done using Market-cap weighting methodology.
Using this approach, analysts need to make only one assumption (macroeconomic scenario) in order to create their model portfolio.
For example, emerging markets are growing faster than developed markets and fast growth means low profitability for new companies in the industry. This means that investors should expect low returns on equity in the long run in these markets. Thus, active management results are not rewarded because of the high level of competition and profit margins are low. Therefore, emerging markets will have a smaller weight in the Top-Down model portfolio than developed countries because higher returns on equity are expected there.
We can also assume that it is more beneficial for companies to expand into new markets. Therefore, the Top-Down model will overweight emerging markets in their investment decisions.
There are many other assumptions that can be used in top-down analysis. For example, the assumption that price-to-earnings ratio is a good metric for determining value of a stock has been questioned by some academic papers, but I believe it is still useful for investors to make this assumption in order to simplify the process of conducting this kind of analysis. Another example is the assumption that industries with higher returns on equity will outperform industries with lower returns on equity in the long run.
This type of analysis gives us a view of how an industry will look like in the future and a view on financial results of companies within that industry. However, it is important to understand that financial results depend on how well or how badly a firm can do with its resources. The more resources a firm has, the more profits it can make. We assume that there are no costs associated with acquiring new resources. In other words, we assume infinite resources for every company within the Top-Down model portfolio.
In reality, firms use limited resources to extract more value from their assets and generate new output from those assets. When using this approach, analysts must stress this fact to investors as an additional assumption in their analysis.
Perhaps the most important part of a Top-Down analysis that makes it an important management tool is that it can determine future financial returns on equity of companies within an industry. The analysis starts from a very basic assumption – world economy will grow, and it is possible to make good guesses about sectors that will grow faster than others. In addition, analysts can adjust for other factors such as technology, quality of management teams, etc.