Tuesday, 30 May 2017

Valuing Cyclical Companies

A cyclical company is one whose earnings demonstrate a repeating pattern of increases and decreases.

The earnings of such companies fluctuate because of large

  • changes in the prices of their products or 
  • changes in volume.

Volatile earnings introduce additional complexity into the valuation process, as historical performance must be assessed in the context of the cycle.

The share prices of companies with cyclical earnings tend to be more volatile than those of less cyclical companies.

However their discounted cash flow (DCF) valuations are much more stable.

Why are the share prices of cyclical companies more volatile?

Earnings forecasts may be the reason that the former is more volatile than the latter.

Analysts' projections of the profits of cyclical companies are not very accurate, in that they tend not to forecast the downturns and generally have positive biases.

Analysts may produce biased forecasts for these cyclical firms from fear of retaliation from the managers of the firms they analyse.

The behaviour of the managers may play a role in the cyclicality.

They tend to increase and decrease investments at the same time (i.e., exhibit herd behaviour).

Three explanations for this behaviour are:

  • cash is generally more available when prices are high,
  • it is easier to get approval from boards of directors for investments when profits are high, and 
  • executives get concerned about the possibilities of rivals growing faster than their firms.

An approach for evaluating a cyclical firm

The following steps outline one approach for evaluating a cyclical firm:

  • construct and value the normal cycle scenario using information about past cycles;
  • construct and value a new trend line scenario based on the recent performance of the company;
  • develop the economic rationale for each of the two scenarios, considering factors such as demand growth, companies entering or exiting the industry, and technology changes that will affect the balance of supply and demand; and 
  • assign probabilities to the scenarios and calculate their weighted values.

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