Question

(a) Explain, using examples, the difference between a ‘top-down’ approach and a ‘bottom-up’ approach to equity valuation.

(b) There are four principles that underlie the concept of efficient markets. Outline, using examples, each principle.

(c) Write out the formula for the constant growth dividend valuation model. What key assumptions are required?

(d) You are interested in buying a share that paid its last annual dividend 9 months ago. You can assume that the next dividend payment (3 months from today) will be €1.50. The company anticipates that dividend growth rates will be 5% annually for the next two dividends and 2% thereafter. Assuming the firm’s cost of equity rE is 9%, how much should you pay for the share?

Answer 1

Answering first three parts

(a) Top-down and bottom-up investing are vastly different ways to analyze and invest in stocks. There are advantages to both methodologies. However, both approaches have the same goal; to identify great stocks. In this article, we'll review the characteristics of both methods.

Top-Down

The top-down approach to investing focuses on the "big picture" or how the overall economy and macroeconomic factors drive the markets and ultimately stock prices. They will also look at the performance of sectors or industries. These investors believe that if the sector is doing well, chances are, the stocks in those industries will also do well.

Top-down investment analysis includes:

• Economic growth or gross domestic product (GDP) both in the U.S. and across the globe,
• Monetary policy by the Federal Reserve Bank including the lowering or raising of interest rates,
• Inflation and the price of commodities,
• Bond prices and yields including U.S. Treasuries.

Bank Stocks & Interest Rates

Below is a chart showing a top-down approach with correlating the 10-year Treasury yield to the Financial Select Sector SPDR ETF (XLF) over the last couple of years.

A top-down investor might look at rising interest rates and bond yields as an opportunity to invest in bank stocks. Typically, not always, when long-term yields rise, and the economy is performing well, banks tend to earn more revenue since they can charge higher rates on their loans. However, the correlation of rates to bank stocks is not always positive. It's important that the overall economy is performing well while yields rise.

Home Builders & Interest Rates

Conversely, suppose you believe there will be a drop in interest rates, using the top-down approach, you might determine that the homebuilding industry would benefit the most from lower rates since lower rates might lead to a spike in new homes purchases. As a result, you might buy stocks of companies in the homebuilding sector.

Commodities & Stocks

If the price of a commodity such as oil rises, the top-down analysis might focus on buying stocks of oil companies like Exxon Mobil Corporation (XOM). Conversely, for companies that use large quantities of oil to make their product, a top-down investor might consider how rising oil prices might hurt the company’s profits. At the onset, the top-down approach starts looking at the macroeconomy and then drills down to a particular sector and the stocks within that sector.

Countries & Regions

Top-down investors might also choose to invest in one country or region if its economy is doing well. For example, if the European economy is doing well, an investor might invest in European ETFs, mutual funds, or stocks.

In short, the top-down approach examines various economic factors to see how those factors may affect the overall market, and therefore certain industries, and ultimately individual stocks within those industries.

For more on the top-down investing, please read A Top-Down Approach To Investing.

Bottom-Up

The bottom-up investing approach, a money manager will examine the fundamentals of a stock regardless of market trends. They will focus less on market conditions, macroeconomic indicators, and industry fundamentals. Instead, the bottom-up approach focuses on how an individual company in a sector is performing compared to specific companies within the sector.

Bottom-up analysis focus includes:

• Financial ratios including the price to earnings (P/E), current ratio, return on equity, and net profit margin,
• Earnings growth including future expected earnings,
• Revenue and sales growth,
• Financial analysis of a company's financial statements including the balance sheet, income statement, and the cash flow statement,
• Cash flow and free cash flow show how well a company generates cash and is able to fund its operations without adding more debt.
• Management's leadership and performance,
• A company's products, market dominance, and market share.

The bottom-up approach invests in stocks where the above factors are positive for the company, regardless of how the overall market may be doing.

Outperforming Stocks

Bottom-up investors also believe that just because one company in a sector is doing well, that does not mean that all companies in the sector will also perform well. These investors try to find the particular companies in a sector that will outperform the others. That’s why bottom-up investors spend so much time analyzing a company. Bottom-up investors typically review research reports that analysts put out on a company since analysts often have an intimate knowledge of the companies they cover. The idea behind this approach is that individual stocks in a sector may perform well, regardless of poor performance by the industry or macroeconomic factors.

However, what constitutes a good prospect, is a matter of opinion. A bottom-up investor will compare companies and invest in them based on their fundamentals. The business cycle or broader industry conditions are of little concern.

Takeaways

A top-down approach starts with the broader economy, analyzes the macroeconomic factors, and targets specific industries that perform well against the economic backdrop. From there, the top-down investor selects companies within the industry. The top-down approach is easier for investors who are less experienced and for those who don't have the time to analyze a company's financials.

A bottom-up approach looks at the fundamental and qualitative metrics of multiple companies and picks the company with the best prospects for the future. Bottom-up investing can help investors pick quality stocks that outperform the market even during periods of decline.

Both approaches are valid and should be considered when designing a balanced investment portfolio.

(b)

The Three Basic Forms of the EMH
The efficient market hypothesis assumes that markets are efficient. However, the efficient market hypothesis (EMH) can be categorized into three basic levels:

1. Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. Given this assumption, rules such as the ones traders use to buy or sell a stock, are invalid.

2. Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and investors purchase stocks after this information is released, an investor cannot benefit over and above the market by trading on new information.

3. Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) no investor would be able to profit above the average investor even if he was given new information.


Weak Form Tests
The tests of the weak form of the EMH can be categorized as:

1. Statistical Tests for Independence - In our discussion on the weak-form EMH, we stated that the weak-form EMH assumes that the rates of return on the market are independent. Given that assumption, the tests used to examine the weak form of the EMH test for the independence assumption. Examples of these tests are the autocorrelation tests (returns are not significantly correlated over time) and runs tests (stock price changes are independent over time).
2. Trading Tests - Another point we discussed regarding the weak-form EMH is that past returns are not indicative of future results, therefore, the rules that traders follow are invalid. An example of a trading test would be the filter rule, which shows that after transaction costs, an investor cannot earn an abnormal return.

Semi-strong Form Tests
Given that the semi-strong form implies that the market is reflective of all publicly available information, the tests of the semi-strong form of the EMH are as follows:

1. Event Tests - The semi-strong form assumes that the market is reflective of all publicly available information. An event test analyzes the security both before and after an event, such as earnings. The idea behind the event test is that an investor will not be able to reap an above average return by trading on an event.
2. Regression/Time Series Tests - Remember that a time series forecasts returns based historical data. As a result, an investor should not be able to achieve an abnormal return using this method.

Strong-Form Tests
Given that the strong-form implies that the market is reflective of all information, both public and private, the tests for the strong-form center around groups of investors with excess information. These investors are as follows:

1. Insiders - Insiders to a company, such as senior managers, have access to inside information. SEC regulations forbid insiders for using this information to achieve abnormal returns.
2. Exchange Specialists - An exchange specialist recalls runs on the orders for a specific equity. It has been found however, that exchange specialists can achieve above average returns with this specific order information.
3. Analysts - The equity analyst has been an interesting test. It analyzes whether an analyst's opinion can help an investor achieve above average returns. Analysts do typically cause movements in the equities they focus on.
4. Institutional money managers - Institutional money managers, working for mutual funds, pensions and other types of institutional accounts, have been found to have typically not perform above the overall market benchmark on a consistent basis.

(c) Constant (Gordon) Dividend Growth Model:

P=D/k-g Where: P=security\'s price; D=dividend payout ratio; k=required rate of return (derived from the capital asset pricing model; g=dividends\' expected growth rate.

The model's assumptions are that: (i) the dividend growth rate is constant; the growth rate cannot equal or exceed the required rate of return; the investor's required rate of return is both known and constant. In practice, a company's earnings and growth rates are not known and not constant.