The destination of any business analysis is to forecast the topline (Revenue/GMV/Order Book) and than using revenue numbers derive the bottom-line (EBITDA/EBIT/PAT) & Free cash Flows (FCFF) a business can generate 3/5/10 years down the line.
There are broadly two approaches investors & analyst use in this forecasting process.
a) Top down:
This approach becomes extremely crucial in industries like Retail, AMC, Insurance, Consumer Durables, diagnostics etc where key growth driver of companies is expansion of industry size lead by a shift in the nature of consumer or some demographics factors like increasing per capita income or under-penetration of goods or economic phenomena like China+1 or import substitution etc.
Because in some business where growth runway is clearly visible and companies are growing at a brisk pace of 15-25% it becomes very important to judge the saturation point or the potential industry size till where such growth can continue.
Obviously having a big opportunity size is no guarantee that a company will be able to grow as it depends a lot on the bottom-ups side i.e. what are company's capex plans, management execution track record, cost controls etc.
Note: please read our this blogpost to understand calculation towards Re-investment rates (Invested capital) here.
b) Bottom-Up Approach:
In bottom ups approach our major perspective is what actions our company is taking in terms capturing the huge opportunity size they in front of them like entering new sub-segments, launching new products in the same segment, setting up new capacities/plants, increasing capacity utilization of existing plants, increasing distributors, team building & branding etc.
A Basic Process for a capex driven company will look something like this
a) What is quantum of Capex that a company will do in coming years (Capex Run rate of the company) and from where this Capex will be funded (internal accruals, Debt, Equity Issuance etc.)
b) Have an Idea about the timeline in which company will be able to complex capex and start with commercialization (actual production after small dispatches for quality sample). A clear example which comes to the mind is PU plant delay for years of Mayur Uniquoters
c) Have an idea about the timeline in Capacity utilization
d) What is the turnover that the company can maintain & what revenue the company can clock?
e) What will be the margins of the company?
f) Calculate expected EBITDA/EBIT/PAT of the company is derived
Through this we try to estimate the topline of the company and than judging trends of costs, operating leverage, economies of scale, initiatives like backward integration, supply chain efficiencies etc we try to understand margins the company can generate in the future which will give us EBITDA/PAT of the company.
Below you will find link to our YouTube session where in detail we have explained the above process using a live case study:
https://www.youtube.com/watch?v=uXHR9t6wqbg
In markets we have consistently seen people fighting over whther Top-down approach makes more sense or bottom-ups. We have in fact seen people who use Bottom-Ups Approach state -"Hum hai asli Value Investors 😀😀😀. Well we belong to the society that everything has a usage and it depends on the which parameter you are analyzing of a business.
For example a basic math will prove organized retail is still very under-penetrated industry in India and a basic shift from unorganized to organized will continue for decades (due to inflexion in per capita incomes, cost saving/value retailing, changing consumption pattern etc.) to come leading to huge opportunity size i.e. huge runway for growth for organized retail companies, but this growth is available to all the retail players. So who will capture the most quantum of growth being profitable is a question that should be asked. For this an analyst will have to go bottom-ups and analyze efficiency in terms of costing, supply Chain, SKU (stock keeping units - basically means variety of products kept in a store) management and Capex plans for opening new store & capturing online delivery market.
Conclusion: Everything has a usage, you should know when to use what.
With these basics in mind do read our next blog where we go in-depth into top-down method and teach you all the analytical angles required to forecast Industry size for a business.