Valuation, 7th Edition

37Cyclical Companies

A cyclical company is one whose earnings demonstrate a repeating pattern of significant increases and decreases. The earnings of cyclical companies, including those in the steel, airline, paper, and chemical industries, fluctuate because the prices of their products change dramatically as demand and/or supply varies. The companies themselves often create too much capacity. Volatile earnings within the cycle introduce additional complexity into the valuation of these cyclical companies. For example, historical performance must be assessed in the context of the cycle. A decline in recent performance does not necessarily indicate a long-term negative trend, but rather may signal a shift to a different part of the cycle.

This chapter explores the valuation issues particular to cyclical companies. It starts with an examination of how the share prices of cyclical companies behave. This leads to a suggested approach for valuing these companies, as well as possible implications for managers.

Share Price Behavior

Suppose you were using the discounted-cash-flow (DCF) approach to value a cyclical company and had perfect foresight about the industry cycle. Would the company’s value and earnings behave similarly? No. A succession of DCF values would exhibit much lower volatility than the earnings or cash flows. DCF reduces future expected cash flows to a single value. As a result, any single year is unimportant. For a cyclical company, the high cash flows cancel out ...