Sometimes, bottom-up investors go wrong by stopping their investigation at the company level and not doing any further research, which leaves them open to choosing companies that look great but are in industries that are struggling or downright doomed.
Bottom-up versus top-down investing
In bottom-up investing, investors are looking for company-specific information to help guide their decision and will only move through the rest of the economic layers if the company seems worth it. This can be a bit of a time killer if the industry as a whole is problematic, but most of the time, you know which industries will be trouble going in and adjust accordingly.
In top-down investing, you instead look at the overall economy and the company's role in it first, then the industry, and last, the company. This is better for evaluating companies in industries that might be newer or potentially on shaky ground. You want to be sure the economic fundamentals surrounding the industry are solid before looking at the company, so you can save a lot of time by skipping all the balance sheets if they're not.
What are some examples of metrics for bottom-up investors?
Every investor has metrics that they love and consider vital, as well as metrics they consider to be a waste of time. There are some pretty common metrics used by bottom-up investors in most sectors. These include:
Indebtedness. How much debt a company carries can affect how quickly it can pivot and how well it can take a financial hit. After all, not every year, or every business cycle, is going to be a good one. If there's a bad year, can that company survive, or does it have so much debt that bankruptcy is almost guaranteed at some point? The only time a lot of debt generally makes sense is if the company is rapidly expanding and has a plan to pay the debt down quickly; even then, it can be a gamble. How much debt is too much depends largely on the industry, so you'll need to compare your company's debt to what’s normal in its sector.
P/E ratio. The price-to-earnings ratio is a popular metric among stock investors. It indicates how well the company's stock is priced by comparing actual earnings to the price of the stock at any given point in time. Again, you'll need to compare your stock to others in the same industry to see how the P/E ratio stacks up since this can vary by category.
Free cash flow. Although net income is often used to evaluate a company's profitability, free cash flow (FCF) gives you a better idea of how well the company is running – and that's what you want to know as a long-term investor. FCF is what's left when you take the net cash from operating activities and subtract the capital expenditures. This can tell you how well this company is actually managing the money that's coming in. It's important to see how businesses operate before you invest in them.
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