The top down approach to security analysis is an important part of the stock valuation and investment decision process. Here is an overview of how it is used:
The top down approach first looks at the overall economic environment and major macroeconomic factors like GDP growth, interest rates, inflation etc. This provides context on the broad market conditions.
Based on the economic analysis, the approach identifies attractive industries and sectors to invest in. For example, certain sectors like technology or healthcare may be poised for growth based on economic trends.
Within the attractive sectors, the top down approach screens for fundamentally strong companies with competitive advantages, growth potential and quality management. Both quantitative metrics and qualitative factors are used.
For the screened companies, detailed valuation models are built from the top down perspective. Revenue, earnings and cash flow forecasts are derived in context of sector/industry projections.
The valuation models give target prices which are compared to current market prices. This indicates whether a stock is undervalued or overvalued.
Finally, buy/sell decisions are made based on the upside potential to target price vs market price. Stocks with high upside are bought, while overvalued stocks are sold.
So in summary, the top down approach provides the macroeconomic context, identifies promising sectors, screens for strong companies within those sectors, conducts valuation modeling from a big picture view, and ultimately guides buy/sell decisions - thereby playing an integral role in stock analysis.