How to Value Cyclical Stocks

Why a Smooth Earning Curve May not be Optimal

How to Value Cyclical Stocks
November 19, 2014

One of the keys to success in stock market investing is being able to determine accurately the value of a business in which you’re considering investing. Earnings are one of the main factors most investors look at when valuing publicly traded companies.

For businesses in relatively stable industries, recent earnings history is usually a good measuring stick for determining the company’s current valuation. But what about companies in industries where success is highly dependent on the condition of the overall economy?

Cyclicals Feature Big Earnings Swings

Businesses like this are sometimes referred to as “cyclical” companies and their stocks as cyclical stocks. Such businesses can swing from huge profits one year to steep losses the next year if the economy takes a nosedive. This is because they manufacture and sell mostly discretionary products that people buy when economic times are good and cut back on when times are bad.

Some of the most recognized cyclical businesses include automobile manufacturers and dealers, furniture manufacturers and retailers, clothing retailers, restaurants, hotels and airlines. Consumers are more likely to buy cars, clothes and furniture, go out to eat, and take trips if the economy is booming and they have extra money to spend. If the economy is teetering, they didn’t get a raise this year or they are worried about getting laid off, they’re much less likely to splurge on these types of discretionary purchases.

One of the things that make investing in cyclical stocks so tricky is valuing the stock — especially if the company’s earnings have fluctuated wildly in recent years. For example, the 10-year earnings history for a major automobile manufacturer featured annual earnings as low as $1.77 and $2.13 a share and as high as $8.53 and $8.62 a share. Such wild fluctuations in annual earnings make it difficult for investors to decide what is the right price to pay for the shares of a cyclical stock right now.

A Cyclical Valuation Strategy

One strategy for valuing cyclical stocks is to determine the average annual earnings of the company over a longer time period than you would consider for non-cyclical stocks. Some experts recommend that a minimum 10-year period should be used to determine a cyclical business’ average annual earnings. Historically, this has been enough time to even out the peaks and valleys of annual earnings over an entire business cycle.

Using the example of the major auto manufacturer above, the average annual earnings per share over the 10-year period was $4.66. Therefore, investors could consider this a good share price benchmark, along with expectations for the company’s future growth and profits.

Investing in cyclical stocks can be tricky business, requiring a different method for determining the right share price benchmark. It is important to take a longer-term historical perspective when determining the average annual earnings of a cyclical business.

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