What is bottom-up investing (short definition)
– Bottom-up investing is a stock-selection method that begins with detailed analysis of a single company’s fundamentals (its financial statements, business model, management, products, etc.) and only later brings in industry and macroeconomic context. The method assumes a well-run company can outperform its peers or the broader market even when its industry or the economy is weak.
Key ideas (concise)
– Focus starts at the micro level (company) and “works up” to sector and macro data.
– Emphasis is on fundamental analysis — reading income statements, balance sheets, cash-flow statements and key ratios.
– Typical strategy: long-term, buy-and-hold; investors often prefer companies they understand from real-world use.
– Bottom-up is the opposite of top-down investing, which starts with the macro picture and narrows down to sectors and stocks.
How bottom-up investing works — step-by-step checklist
1. Idea generation
– Find companies you can study or use (customer experience, personal knowledge, or screening tools).
2. Read the basics
– Annual reports, 10‑Ks/10‑Qs, earnings releases, and investor presentations.
3. Financial review (quantitative)
– Compute core metrics: revenue growth, net income, earnings per share (EPS), gross & operating margins, free cash flow, return on equity (ROE).
– Calculate valuation metrics: price-to-earnings (P/E), enterprise value/EBITDA (EV/EBITDA), price-to-book (P/B).
4. Qualitative analysis
– Assess competitive advantage (moat), management quality, product relevance, customer concentration, regulatory risk.
5. Peer and industry comparison
– Compare financials and valuation metrics to direct competitors and the industry median.
6. Macro and sector check
– Consider interest rates, inflation, commodity prices, and whether sector trends support or threaten the business.
7. Valuation & decision rules
– Decide entry price ranges, position sizing, and exit criteria based on valuation and risk tolerance.
8. Monitor and revise
– Track quarterly results and key indicators; update thesis if fundamentals or risks change.
Definitions of common terms (first-time readers)
– Fundamental analysis: examining a company’s financials and business factors to estimate its intrinsic value.
– P/E ratio (price-to-earnings): market price per share divided by earnings per share (EPS); a basic valuation metric.
– EPS (earnings per share): company net income divided by shares outstanding.
– PEG ratio: P/E divided by projected earnings growth rate (as a percentage); used to adjust P/E for growth expectations.
– Buy-and-hold: a long-term strategy of purchasing a stock and holding it for an extended period rather than frequent trading.
Small
Small-cap: companies with relatively low market capitalization (commonly under about $2–3 billion); typically have higher growth potential and higher volatility than larger firms.
Mid-cap: companies with medium market capitalization (roughly $2–3 billion to $10–15 billion), a balance of growth and stability.
Large-cap: companies with high market capitalization (above mid-cap), generally more stable and widely followed.
Margin of safety: the difference between your estimate of intrinsic value and the market price, expressed as a percentage. A larger margin reduces the risk that valuation errors will result in a loss.
Intrinsic value: an estimate of a company’s “true” worth based on fundamentals (discounted cash flows, liquidating value, or comparable multiples), not the current market price.
Free cash flow (FCF): cash a company generates after capital expenditures. Common formula: FCF = Operating cash flow − Capital expenditures.
Return on equity (ROE): net income divided by shareholders’ equity; measures how efficiently a company uses equity capital.
Beta: a measure of a stock’s historical volatility relative to the overall market (beta >1 = more volatile; beta threshold).
2. Quantitative screen
– Revenue growth (e.g., 3–5 year CAGR > X%).
– ROE or ROIC (return on invested capital) above peer median.
– FCF positive and growing.
– Reasonable leverage (debt/EBITDA or debt/equity within acceptable range).
– Valuation filters (P/E, EV/EBITDA, or PEG within target).
3. Qualitative filter
– Business model clarity and competitive position.
– Management track record and incentives.
– Regulatory or technological risks.
– Customer concentration and supplier risks.
4. Valuation
– Perform at least two methods (relative multiples and a simple DCF).
– Calculate intrinsic value per share and margin of safety.
5. Position sizing and rules
– Determine size per position based on risk tolerance and diversification rules.
– Set explicit entry, stop-loss, and target-exit criteria (or rules for re-evaluation).
6. Monitoring and review
– Quarterly checks on revenue, margins, guidance, and major events.
– Revisit thesis if key assumptions change.
Worked numerical example (simple DCF + margin of safety)
Assumptions for hypothetical “ABC Corp”
– Latest FCF (this year) = $8.0 million.
– Forecast FCF growth = 10% per year for 5 years.
– Terminal growth rate g = 2% after year 5.
– Discount rate (WACC) = 10%.
– Net debt = $20 million.
– Shares outstanding = 10 million.
Step A — Project FCF for 5 years
Year 1 FCF = 8.0 × 1.10 = 8.80
Year 2 FCF = 8.80 × 1.10 = 9.68
Year 3 FCF = 10.648
Year 4 FCF = 11.7128
Year 5 FCF = 12.88408
Step B — Discount the 5-year FCFs to present value
PV = Σ [FCF_t / (1 + WACC)^t]
Using WACC = 10%, the discounted PVs here sum roughly to $40 million (in this example the math simplifies because growth = discount rate
rate).
Step C — Calculate terminal value (Gordon growth) and its present value
– Terminal value (TV) at end of Year 5 using the Gordon (perpetuity) formula:
TV = FCF5 × (1 + g) / (WACC − g)
= 12.88408 × 1.02 / (0.10 − 0.02)
= 13.1417616 / 0.08
= 164.27202 (million)
– Discount the terminal value back to present:
PV(TV) = TV / (1 + WACC)^5
= 164.27202 / 1.61051
≈ 101.985 (million)
Step D — Compute enterprise value, equity value, and per‑share value
– PV of Year 1–5 FCFs (from Step B) = 40.000 (million)
– PV of terminal value = 101.985 (million)
– Enterprise value (EV) = PV(FCFs) + PV(TV) = 40.000 + 101.985 = 141.985 (million)
– Subtract net debt to get equity value:
Equity value = EV − Net debt = 141.985 − 20 = 121.985 (million)
– Per‑share intrinsic value = Equity value / Shares outstanding
= 121.985 / 10 = 12.1985 → ≈ $12.20 per share
Quick checklist (for your own DCF runs)
1. Verify base-year FCF (definition: free cash flow available to all capital providers after operating expenses and reinvestment).
2. Choose realistic multi‑year growth rates and terminal growth g (g should be <= long‑run GDP/inflation for stability).
3. Estimate discount rate (WACC) and explain components (cost of equity, cost of debt, capital structure).
4. Project FCFs, compute PVs year by year.
5. Compute terminal value, discount to present.
6. Sum PVs, adjust for net debt and non-operating assets, divide by shares.
7. Run sensitivity analysis for WACC and g (small changes can produce large valuation swings).
8. Document all assumptions and rounding conventions.
Worked‑example recap (assumptions)
– Base FCF = 8.0 million; growth 10% for 5 years; WACC = 10%; terminal g = 2%; net debt = 20 million; shares = 10 million.
– Result: intrinsic value ≈ $12.20 per share.
– Note: this result follows the model and inputs exactly; changing WACC or terminal g materially changes the outcome.
Key caveats and sensitivity
– Terminal value often dominates EV; here PV(TV) ≈ 72% of EV. That concentration makes the valuation highly sensitive to g and WACC.
– WACC and g are estimated, not observed; justify choices and test alternatives.
– DCF gives an intrinsic-value estimate under the model’s assumptions; real markets reflect other factors (liquidity, information, competitive change, execution risk).
Educational disclaimer
This is an illustrative valuation for learning purposes only. It is not personalized investment advice or a recommendation to buy or sell any security.
References
– Investopedia — Discounted Cash Flow (DCF): https://www.investopedia.com/terms/d/dcf.asp
– Aswath Damodaran (NYU
– Aswath Damodaran (NYU Stern) — Damodaran Online (valuation datasets, spreadsheets, teaching material): https://pages.stern.nyu.edu/~adamodar/
– U.S. Securities and Exchange Commission (SEC) — EDGAR company filings (primary source for financial statements): https://www.sec.gov/edgar/searchedgar/companysearch.html
– Investopedia — Discounted Cash Flow (DCF) overview and examples: https://www.investopedia.com/terms/d/dcf.asp
– Khan Academy — Present value, discounting, and DCF tutorials (introductory lessons): https://www.khanacademy.org/economics-finance-domain/core-finance/interest-tutorial/present-value-tutorial
– McKinsey & Company — Insights on valuation and corporate finance (practical frameworks and research): https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights
Educational disclaimer: This material is for educational purposes only. It does not constitute individualized investment advice, a recommendation to buy or sell securities, or a forecast of future performance. Always perform your own research and consider consulting a licensed financial professional before making investment decisions.