Learning Outcomes
After reading this article, you will be able to explain the role of industry and company analysis in security selection, distinguish between top-down and bottom-up forecasting methods, and evaluate the merits and limitations of each framework. You will know how external (macro, industry) and internal (firm-level) factors influence revenue, cost, and earnings estimates, and be equipped to apply these approaches in the CFA Level 1 exam context.
CFA Level 1 Syllabus
For CFA Level 1, you are required to understand the methods used for industry and company analysis that feed into security valuation. This includes the ability to:
- Differentiate between top-down and bottom-up forecasting methods.
- Describe the process of moving from industry forecasts to company-level estimates.
- Identify key external and internal factors affecting company performance.
- Evaluate the implications of macroeconomic, sector, and company-specific variables on earnings forecasts.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which approach would an analyst use if they start with GDP and sector projections before estimating a firm's revenues?
- What industry characteristics might lead to greater forecast uncertainty at the company level?
- In what situation is a bottom-up approach preferred for equity analysis?
Introduction
Industry and company analysis provide the basis for security valuation. Forecasting—the process of estimating the future financial performance of firms—can be approached using top-down or bottom-up techniques. Understanding both frameworks, and knowing when to use each, is essential for CFA candidates.
Key Term: top-down forecasting
An approach to financial analysis that begins with macroeconomic indicators, moves to sector trends, and then to individual company projections.Key Term: bottom-up forecasting
A company-centric approach to financial analysis that builds financial projections by aggregating firm-specific data without explicit linkage to macro or industry forecasts.
Top-Down Forecasting Approach
The top-down method starts at the broadest level: macroeconomic trends such as GDP, inflation, interest rates, and policy changes. Next, the analyst focuses on sectors or industries, factoring in drivers such as regulatory changes, technology adoption, demographics, and competition. After industry-level conditions are examined, analysts estimate the potential market share and growth for the target company, adjusting for management quality, strategy, and unique strengths or vulnerabilities.
Key Term: industry analysis
Evaluation of a group of companies producing similar products or services, focusing on competitive structure, growth prospects, and key risk factors.
Worked Example 1.1
Question: An analyst is forecasting sales for a consumer electronics company. She starts with GDP growth projections, then estimates expected industry growth, and only then forecasts individual company sales. What approach is she applying, and what are the advantages?
Answer:
She is applying a top-down forecasting approach. Advantages include consistency with macro conditions, better alignment with aggregate growth and broad trends, and a structured process for cross-company comparisons.
Bottom-Up Forecasting Approach
The bottom-up method directly estimates a company’s future performance, typically by starting with internal drivers such as product pipelines, business initiatives, salesforce expansion, or management guidance. These projections may then be summed across companies to estimate industry-level forecasts.
This approach can be helpful for companies with highly differentiated products or market strategies, or when the company’s own circumstances are more critical to future performance than sector or macro trends.
Worked Example 1.2
Question: An analyst develops a forecast of revenues by adding up the sales projections for each region and product line based only on company data and management discussions. What approach is this, and what risk does it entail?
Answer:
This is a bottom-up forecasting approach. The risk is that it may ignore broader industry or macroeconomic factors, which could make the forecast inconsistent with external trends or vulnerable to over-optimism.
Comparing Top-Down and Bottom-Up Forecasting
Both methods have value. Top-down ensures forecasts are anchored to economic realities and helps preserve internal consistency across companies within an industry. It also provides a macro context for assumptions about growth or market share. Bottom-up allows flexibility and specificity when company-level factors or strategic actions drive results.
Analysts should be aware of the limitations of each:
- Top-down may overlook individual company advantages, unique risks, or major structural shifts at the micro level.
- Bottom-up may ignore the impact of cyclical changes, sector slowdowns, or rising input costs tied to economic factors outside the company’s control.
Key Term: forecast consistency
The degree to which individual company forecasts align with sector, industry, and macroeconomic expectations.
Drivers and Limitations
Key factors influencing forecast accuracy include:
- Structure and cyclicality of the industry (e.g., durable goods are more volatile than utilities).
- Market concentration, barriers to entry, and regulatory conditions.
- Company differentiation, competitive strengths, and management execution.
A thorough approach may combine elements of both methods: starting with top-down to set boundaries, then using bottom-up analysis to refine company-specific projections.
Worked Example 1.3
Question: When would an analyst likely favor a bottom-up approach over a top-down approach?
Answer:
When a company's prospects are dominated by factors such as a new patented product, major cost-reduction program, or unique access to a new market—regardless of macro or sector conditions.
Exam Warning
A common error is to use bottom-up forecasts in aggregate without checking whether the sum aligns with overall industry or macro projections. Always check for aggregation errors and implausible market share assumptions.
Revision Tip
For CFA exam questions, remember: Top-down = macro to micro; bottom-up = micro to macro. Know at least two strengths and weaknesses of each.
Summary
Top-down forecasting starts with the economy and works down to sector and company projections. Bottom-up forecasting starts at the company level and may be rolled up to create industry or sector estimates. Effective analysis may require combining both methods. CFA candidates must be able to distinguish each framework and rationalize their use in practical scenarios.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and contrast top-down and bottom-up forecasting frameworks.
- Identify which industries or scenarios favor each approach.
- Understand key internal and external drivers behind estimates.
- Recognize the importance of consistency between forecasts at different levels.
Key Terms and Concepts
- top-down forecasting
- bottom-up forecasting
- industry analysis
- forecast consistency