Valuing Cyclical Companies
How to value a business whose profits rise and fall with the economy, by estimating what it earns across a whole cycle instead of in any one year.
The short version
A cyclical company's profit in any single year says more about where the economy is than about the company. At the top of a cycle, profit is high and the price-to-earnings ratio looks low, just before profit falls. At the bottom, profit vanishes and the ratio looks terrible, just before recovery. The fix is to normalize: work out the margin the company earns on average over a full cycle, apply it to a normal level of sales, and value that. Then check that the balance sheet can survive the bottom, because a cyclical company with too much debt may not be around to enjoy the recovery.
By the end of this lesson, you'll be able to
- Explain why earnings multiples mislead at the top and bottom of a cycle
- Calculate normalized earnings from a full cycle of results
- Test whether a cyclical company can survive the bottom of its cycle
Why this matters
Makers of trucks, machinery, steel, chemicals, and building materials, along with airlines, homebuilders, and many others, sell things customers can put off buying. When the economy slows, their sales fall sharply, and because many of their costs are fixed, their profits fall much further. Business Cycles and Recessions covered the cycle itself. This lesson is about valuing a business that lives inside one.
The methods so far all lean on a current figure: this year's profit, or cash flow growing from today's level. For a cyclical company, today's figure is the one number you can be sure isn't typical.
A full cycle
| Year | Revenue | Operating margin | Operating income |
|---|---|---|---|
| 1 | 800 | 6% | 48 |
| 2 | 900 | 9% | 81 |
| 3 | 1,050 | 12% | 126 |
| 4 (peak) | 1,200 | 13% | 156 |
| 5 | 1,000 | 9% | 90 |
| 6 | 800 | 3% | 24 |
| 7 (trough) | 700 | −2% | (14) |
| 8 | 850 | 6% | 51 |
| Total | 7,300 | 7.7% | 562 |
From peak to trough, revenue fell 42% and operating income went from $156 million to a loss. Over the whole eight years the company earned $562 million on $7,300 million of sales, a margin of 7.7%, and averaged about $70 million of operating income a year. No single year looked like the average.
Why multiples point the wrong way
Suppose investors value Company C at $1,400 million in year 4 and $600 million in year 7.
| Year 4 (peak) | Year 7 (trough) | |
|---|---|---|
| Enterprise value | 1,400 | 600 |
| Operating income that year | 156 | (14) |
| Multiple of that year's operating income | 9.0 | Not meaningful |
| Average yearly operating income over the cycle | 70 | 70 |
| Multiple of average operating income | 19.9 | 8.5 |
On the year's own profit, Company C looks cheap at the peak, at 9 times, and impossible to value at the trough. On what it earns across a cycle, the picture reverses: nearly 20 times at the peak and under 9 at the trough. The market wasn't being foolish in year 4. A multiple of 9 on peak profit already assumed profit would fall. An investor who saw "9 times earnings" and bought was paying a full price for an average business.
This is the trap Why Cheap Isn't Always Undervalued described. For cyclical companies, a low multiple is often a sign of a peak, and a high or meaningless one can be a sign of a trough.
The rest of this lesson is for members
Still to come in this lesson: Normalizing, Surviving the trough, Reading where you are, the key takeaways, and 2 quiz questions with explanations.
Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.
Go deeper
- Valuing Banks and InsurersValuation and Modeling (depth track)
- Energy and Commodity ProducersFinancial Statement Analysis in Depth (depth track)
- Business Cycles and RecessionsPart 6: Strategy, Behavior, Accounts, and Taxes
- Why Cheap Isn't Always UndervaluedPart 4: Research and Valuation