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MaxMark_Ch07_Correct_Answers - MenuItem 7(Topic...

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MenuItem 7: (Topic 7)Forecasting share price movements Question 1: The bottom-up approach is one form of fundamental analysis. Which of the following statements in relation to the bottom-up approach is most accurate? ‘The bottom-up approach: A: identifies differences in systematic risk between industry sectors’ B*: is applied to select specific stocks from within preferred industry sectors’ C: identifies a well diversified portfolio that eliminates unsystematic risk’ D: provides investment indicators based on forecast financial ratios’ Feedback: The bottom-up approach to security analysis begins by focusing on forecasts of returns for individual stocks in an effort to distinguish those that are attractive for purchase from others that should be sold. Answer B is the only answer that is consistent with the nature of the bottom-up approach. MORE: Financial Institutions, Instruments and Markets 5/e , p. 295. The investor has a number of choices of company shares to buy within each of those sectors. In which companies should the investor purchase shares? How can the investor make an informed investment decision? Fundamental analysis using the bottom-up approach assists an investor with that analysis. The fundamental analysis bottom-up approach considers micro factors that indicate a firm’s financial performance and its operational and management performance. The approach focuses on accounting ratios and other measures of a firm’s performance. Question 2: The bottom-up approach to fundamental analysis considers the micro factors that reflect a company’s performance. Bottom-up analysis may suffer from a major weakness in that: A: it can be difficult to incorporate differences in risk between companies B: unsystematic risk is difficult to estimate C: financial performance is difficult to assess D*: the data that is most readily available relates to the past Feedback: The main purpose of fundamental analysis is to identify investments that will be attractive in the future and this involves making forecasts of variables such as earnings, cash flows and dividends. Accounting data and most other available information is historic, which can be a major limitation. MORE: Financial Institutions, Instruments and Markets 5/e , p. 297. While the detail and the discipline of the bottom-up approach is appealing to many investors, the approach may suffer from a major drawback. The drawback relates to the need to calculate the performance ratios using historic data. The historic data provides useful information on past performance, which may be an indicator of future performance, but it is also possible that future performance may be different. This raises the question of how to forecast the future direction of the performance of a firm, the industry sector and the stock market generally. The fundamental analysis solution is to combine a top-down approach with the bottom-up approach.
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