Valuation: Measuring and Managing the Value of Companies, Fifth Edition

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Valuing Cyclical Companies

A cyclical company is one whose earnings demonstrate a repeating pattern of significant increases and decreases. The earnings of such companies, including those in the steel, airline, paper, and chemical industries, fluctuate because of large changes in the prices of their products. In the airline industry, earnings cyclicality is linked to broader macroeconomic trends. In the paper industry, cyclicality is largely driven by industry factors, typically related to 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, and a decline in recent performance does not necessarily indicate a long-term negative trend, but rather a shift to a different part of the cycle.

In this chapter, we explore the valuation issues particular to cyclical companies. We start with an examination of how the share prices of cyclical companies behave. This leads to a suggested approach to valuing these companies, as well as possible implications for managers.

SHARE PRICE BEHAVIOR

The share prices of companies with cyclical earnings tend to be more volatile than those of less cyclical companies. But their discounted cash flow (DCF) valuations are much more stable. So are cyclical companies exceptions to the rule that market values generally track return on invested capital (ROIC) and growth (see Chapter 15)?

When Market and ...