Reference no: EM132973085

Identify and interpret economic variables that impact on share price movements within the context of the top-down approach to fundamental analysis.

• The price of a share is essentially determined by the demand for and supply of the share. At any moment, the balance between buyers and sellers of a company's shares is determined by their assessment of the future profitability of a company and forecast movement in the share's price.
• Investors and share analysts may conduct their evaluations and issue their buy/sell recommendations using fundamental analysis.
• Fundamental analysis, incorporating the top-down approach and the bottom-up approach, examines variables that finance and economic theories identify as being relevant to a company's future performance.
• The top-down approach looks at prospective developments in the broader economic environment within which the various industry sectors and specific companies are situated.

Important variables that are identified as being of relevance to the future performance of various industry sectors, and therefore companies operating within those sectors, include:

1. developments in major international economies - the rate of growth within a domestic economy
2. the variability and volatility of exchange rates, particularly those of major trading partners
3. changes in monetary policy settings and movements in interest rates
4. the balance of payments current account, and whether the current account is in surplus or deficit - upward pressures on wages growth relative to increases in productivity.

Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in particular the analysis of the financial and operational performance of a corporation.

1. Once an investor has determined which economies and which industry sectors offer the most attractive investment opportunities (using the top-down approach), the investor must conduct an analysis of firms in those sectors to decide which shares to buy or sell.
2. The fundamental analysis bottom-up approach uses accounting ratios and other performance measures to analyse the financial, operational and management performance of a particular company.
3. Ratios that are analysed include capital structure, liquidity, debt servicing, profitability, share price and equity, and risk.
4. Ratios will be measured over time and compared with those of similar corporations in the same industry. (Note: Ratios use historic data which may not accurately reflect future performance.)
5. Other indicators include key management, corporate governance and strategic direction.

Problem 1: An investor is evaluating the use of the bottom-up approach and the top-down approach to fundamental analysis. The investor wants to use the approach that will best enable them to structure a diversified share portfolio that will achieve specified income returns and capital gains. Which approach do you recommend the investor adopt?