Valuing Cyclical Stocks explained by professional Forex trading experts the “ForexSQ” FX trading team.
Valuing Cyclical Stocks
For as long as capitalism has existed, there have been businesses whose fortunes rise and fall with the economy as a whole. These “cyclicals” (as financial professionals refer to them) can go from generating breath-taking profits one year, to devastating losses the next.
Identifying a Cyclical Business
Identifying a cyclical business is relatively easy. They often exist along industry lines. Automobile manufacturers, oil companies, and steel or aluminum producers are classic examples.
Consider Ford or General Motors. Demand for their products is almost entirely connected to the level of personal income nationwide, which is a measure of the broad economy’s health. When a recession or even slight economic downturn becomes visible on the horizon, these businesses begin to lose market value almost immediately – and for good reason. When a family member is laid off, or disposable income gets tight, people put off buying a new car.
A closer look at General Motors gives investors a perfect understanding of the cyclical concept. Consider the earnings history for the car manufacturer from 1993 to 2001:
- 2001 = $1.77
- 2000 = $6.68
- 1999 = $8.53
- 1998 = $4.18
- 1997 = $8.62
- 1996 = $6.07
- 1995 = $7.28
- 1994 = $6.20
- 1993 = $2.13
- 1993 = ($4.85)
Thinking back to the early 1990s, investors will remember that the United States was in the midst of a recession and the Persian Gulf War. The economy as a whole was not in terrific shape.
In the pursuing years, the economy picked up and roared into the greatest bull market this country had ever seen. The successive climb in profits is visible throughout the entire decade (notice 1998 when Wall Street was concerned stock prices were overvalued and the economy was, for a moment, slightly unstable.
These events led straight to GM’s bottom line, with a 50% drop in profits over the course of the year.)
The company’s most recent annual report reveals earnings were down more than 73.5%. This was the first full year after the economy began to correct itself, and like all cyclicals, General Motors was one of the first enterprises to feel the impact.
How to Value Cyclical Stocks
This presents the obvious problem of valuation. How much should an investor be willing to pay for a cyclical business?
Ben Graham, the “Dean of Wall Street” and father of value investing, came up with a solution almost seventy years ago. He maintained that an investor should pay based upon the average earnings of a cyclical business for the past ten years. Historically, this timeframe has covered an entire business cycle, evening out the highs and lows.
Had an investor valued GM in 1999 when earnings-per-share were $8.53, he would have paid many times what the company was worth. Instead, he should have based his estimate of future earnings on 1.) the historical growth rate of General Motors, and 2.) the average earnings of $4.66 per share over the past decade.
When Averaged Earnings Are Too High or Low for a Cyclical Stock
In General Motors’ case, even the “average” earnings may be too high an estimate of future profits.
Considering the unprecedented bull market of the 1990’s, it is hard to believe that such elevated levels of earnings can continue indefinitely. If you believe that the United States is headed for a slow-down or full-fledged recession, you should base your average earnings on the historical return the business has provided during other down-cycles. In the past, GM has either lost money or posted $1-2 EPS during these periods. If you expect these conditions to prevail for several years, the average earnings of $4.66 per share may still be too rich.
Valuing Cyclical Stocks Conclusion
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