The Little Book of Valuation, Updated Edition

Chapter ElevenRoller Coaster Investing: Valuing Cyclical and Commodity Companies

WHAT WAS TOYOTA MOTORS WORTH in 2007, when the global economy was booming and the firm was profitable? What about two years later, at a height of recession? If oil prices are expected to surge, how much will Exxon Mobil's stock price go up? Uncertainty and volatility are endemic to valuation, but cyclical and commodity companies have volatility thrust on them by external factors such as ups and downs of the economy and movements in commodity prices. Even mature cyclical and commodity companies have volatile earnings and cash flows, making investing in them akin to riding a roller coaster.

There are two groups of companies that we look at in this chapter. The first group, drawn from sectors such as housing and automobiles, includes cyclical companies, with earnings that track overall economic growth. The second group includes commodity companies that derive their earnings from producing commodities that may become inputs to other companies in the economy (oil, iron ore) or be desired as collectibles (gold, platinum, diamonds).

Both types of companies share some common characteristics that can affect how they are valued.

• The economic/commodity price cycle: Cyclical companies are at the mercy of the economic cycle. The odds are high that most cyclical companies will see revenues decrease in the face ...