Valuing Cyclical Stocks

Assigning Intrinsic Value to Businesses with Unsteady Earnings

Valuing Cyclical Stocks
••• ViewStock / Getty Images

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 in one year to recording devastating losses the next.

From an investor's standpoint, these companies can be hard to evaluate. It can be challenging to fairly judge a stock price with earnings that rise and fall. But these companies can still be very good investments for those who are patient and have a long time horizon.

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 percent drop in profits over the course of the year.)

Examples of Cyclical Stocks

We mentioned auto manufacturers as a prime example of companies that have cyclical earnings. Other industries that might be considered cyclical in nature include:
-Entertainment companies. People go to the movies and buy theme park tickets when they have discretionary income. Thus, these firms are considered cyclical because their earnings rise and fall with the health of the economy.

-Heavy equipment manufacturers. Companies will expand their businesses and desire new equipment when they are doing well. They will hold off on making these expenditures during times of slow economic and business growth.

-Airlines - When people have extra money, they will be more inclined to take that vacation to the Bahamas and fly. When the economy is in a recession, they will stay home.

-Electronics manufacturers - Makers of high-end smartphones, such as Apple, can be considered cyclical because sales are driven by buyers' discretionary income. Makers of flat-screen TVs or other products, such as Sony, would be in a similar category.

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 70 years ago. He maintained that an investor should pay based upon the average earnings of a cyclical business for the past 10 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 the previous 10 years. In this case, it would be about $4.66 per share based on earnings from 1989 to 1999.

Of course, in General Motors' case, even the "average" earnings may be too high an estimate of future profits. This is especially true given that the company required a government bailout following the financial crisis in 2009 and 2009.

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.