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.

Equity Investments - Analyzing a Company - Types of Stock

1. Growth Company and Growth StockA growth company is a company that consistently grows by investing in projects that will generate growth. A growth stock, however, is a stock that earns a higher rate of return over stocks with a similar risk profile.
   
   Feasibly, a company could be a growth company, but its stock could be a value stock if it is trading below its peers of similar risk.

2. Defensive Company and Defensive StockA defensive company is a company whose earnings are relatively unaffected in a business cycle downturn. A defensive company is typically reflective of products that we "need" versus "want". A food company, such as Kellogg, is considered a defensive company. A defensive stock, however, will hold its value relatively well in a business cycle downturn.

3. Cyclical Company and Cyclical StockA cyclical company is a company whose earnings are affected relative to a business cycle. A cyclical company is typically reflects products we "want". A retail store, such as The Gap, is considered a cyclical company. A cyclical stock, however, will move with the market in relation to the business cycle.

4. Speculative Company and Speculative Stock.A speculative company is a company that invests in a business with an uncertain outcome. An oil exploration company is an example of a speculative company. A speculative stock, however, is a stock that has potential for a large return, as well as the potential for considerable losses. An example of speculative stocks can be found in the tech bubble, where investors put money into speculative stocks, but the investor could have been hurt financially or made large gains depending on the stock the investor invested in.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/equity-investments/analyzing-companies-stock-types.asp#ixzz1yf8SKSRC

How to decide what shares to buy?

How to decide what to buy?

When it comes to deciding what shares to buy, the most important thing to consider is your investment goals, in particular, the performance goals you set for the share investments portion of your portfolio.

For example, you might be aiming to achieve an average after-tax dividend yield of 4% p.a. and capital growth of 8% p.a. over the next 10 years.  In that case, you could buy some shares that provide reliable, tax-effective dividends and the expectation of solid year-on-year growth.

Alongside long term investing, there are share trading opportunities that offer the chance to grow your investment capital more quickly.  Active or daily trading carries with it certain risks that need to be considered carefully.  With this in mind, looking at the range of categories that shares fall into can be a useful place to start.

(Long term investors aim to capture an upward trend in market value.  Short term investors try to capture value from the volatility in the share market.)

Income shares - Pay larger dividends, compared to other types of shares, that can be used to generate income without selling the shares, but the share price generally does not rise very quickly.

Blue chip shares - Issued by companies with long histories of growth and stability.  Blue chip shares usually pay regular dividends and generally maintain a fairly steady price trend.

Growth shares -  Issued by entrepreneurial companies experiencing a faster rate of growth than their general industries.  These shares normally pay little or no dividends because the company needs most or all of its earnings to finance expansion.

Cyclical shares -  Issued by companies that are affected by general economic trends.  The share prices tend to fall during periods of economic recession and rise during economic booms.  For example, mining, heavy machinery, and home building companies.

Defensive shares -  The opposite of cyclical shares.  Companies producing staples such as food, beverages, pharmaceuticals and insurance issue defensive shares.  They typically maintain their value during economic downturns.


http://www.asx.com.au/courses/shares/course_01/index.html?shares_course_01

Are Cyclical stocks also Value stocks? Value stocks usually earn money, turnaround stocks may not.

What are the characteristics of value stocks?

1. True value investors only buy if a stock is trading substantially below its tangible book value.  It’s hard finding these types of situations in all your investments.  Use this as a guide and not as a “must have.” Over the years, you will have noticed these types of values in the banking, energy and chemical industries, among others.
2. Another factor you need to find in a value stock is a low price to earnings (“P/E”) ratio.  You are looking for a beaten down stock in an out-of-favor industry. A nice P/E discount is 20% to 50% of the industry average over a few years. You then have the potential to make a nice return on both the natural rotation of the industry to a higher timeliness, as well as the stock regaining market favor. 

When is a cyclical stock also a value stock?


Many investors view cyclical stocks as value stocks. Cyclical stocks are value stocks only if they sell at an earnings (P/E) discount to their peers and meet the book value criteria as mentioned above. 




When is a cyclical stock not value stocks but a turnaround stock?


If the company is selling at a discount to its tangible bookvalue, but its earnings have disappeared, it becomes a possible turnaround situation and not a value stock.

Tongher

Date announced 17/08/2010
Quarter 30/06/2010 Qtr 2
FYE 31/12/2010

STOCK TONGHER
C0DE  5010 

Price $ 1.91
Curr. PE (ttm-Eps) 12.41
Curr. DY 2.62%

Rec. qRev 63560 q-q % chg 8% y-y% chq 42%
Rec qPbt 10015 q-q % chg 76% y-y% chq 2529%
Rec. qEps 4.98 q-q % chg 69% y-y% chq -832%
ttm-Eps 15.39 q-q % chg 58% y-y% chq -2%

Using VERY CONSERVATIVE ESTIMATES:
EPS GR 4%
Avg.H PE 10.00
Avg. L PE 4.00

Current price is at Upper 1/3 of valuation zone.
RISK: Upside -17% Downside 117%
One Year Appreciation Potential 0% Avg. yield 3% Avg.
Total Annual Potential Return (over next 5 years):    3%

CPE/SPE 1.77
P/NTA 0.86
NTA 2.23
SPE 7.00
Rational Pr 1.08


Decision:
Already Owned: Buy Hold Sell Filed
Review (future acq) Filed
Discard Filed
Guide: Valuation zones Lower 1/3 Buy Mid. 1/3 Maybe Upper 1/3 Sell

Aim:
To Buy a bargain. Buy at Lower 1/3 of Valuation Zone
To Minimise risk of Loss. Buy when risk is low i.e UPSIDE GAIN > 75% OR DOWNSIDE RISK <25%
To Double every 5 years. Seek for POTENTIAL RETURN of > 15%.
To Prevent Loss Sell immediately when fundamentals deteriorate
To Maximise Gain & Reduce Loss Sell when CPE/SPE > 1.5, when in Upper 1/3 of Valuation Zone & Returns < 15%/yr


How to value a cyclical stock, like Tongher?

A reasonable method is using the asset valuation method.  Tongher is trading below its NTA.

It is more challenging to use earnings to value cyclical stocks.  Tongher's earnings are affected by the business cycle of its sector.  I have averaged all the existing ttm-EPS figures that I have over the last 26 quarters and this gives an average ttm-EPS of 27.3 sen.  Before the recent global crisis, Tongher was earning about 15 sen per quarter.  It's latest quarter's EPS was 4.98 sen.

Using a conservative estimated ttm-EPS 30.0 sen and the signature PE of 7, I derive a rational value for Tongher of 2.10.  As this value will be on the low side due to the very conservative assumptions made in its derivation, at its current price of 1.91, Tongher is undervalued.


Date announced 17/08/2010
Quarter 30/06/2010 Qtr 2
FYE 31/12/2010

STOCK TONGHER
C0DE  5010 

Price $ 1.91
Curr. PE (ttm-Eps) 6.37
Curr. DY 2.62%

Valuation using Estimated ttm-EPS
ttm-Eps 30.00 sen

Using VERY CONSERVATIVE ESTIMATES:
EPS GR 4%
Avg.H PE 10.00
Avg. L PE 4.00

Current price is at Lower 1/3 of valuation zone.
RISK: Upside 87% Downside 13%
One Year Appreciation Potential 18% Avg. yield 6%
Avg. Total Annual Potential Return (over next 5 years):     24%

CPE/SPE 0.91
P/NTA 0.86
NTA 2.23
SPE 7.00
Rational Pr 2.10

Cyclical Versus Non-Cyclical Stocks

Charting a Cyclical vs. Non-Cyclical Company 
Below is a chart showing the performance of a highly cyclical company, the Ford Motor Co. (blue line), and a classic non-cyclical company, Florida Public Utilities Co. (red line). This chart clearly demonstrates how each company's share price reacts to downturns in the economy. 



Notice that the downturn in the economy from 2000 to 2002 drastically reduced Ford's share price, whereas the growth of Florida Public Utilities' share price hardly batted an eye at the slowdown. 


http://www.investopedia.com/articles/00/082800.asp

Know this chart and you will understand the challenge of investing into cyclical stocks.

Investors cannot control the cycles of the economy, but they can adjust their investing practices with its ebbs and flows. Adjusting to economic transitions requires an understanding of how industries are characterized by their relationship to the economy. It's important for you to know the fundamental difference between cyclical and non-cyclical companies so that you can distinguish between sectors that are affected by economic changes and those that are more immune.