As the title states, anyone in the market uses DCF to value a cyclical business? Or just buy at high multiple (when it's underearning) and sell at low multiple (when at peak earning)?
Tks.
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Comments ( 11 )
thoughts?
Look into consumer discretionary stocks. Maybe ask someone you know that covers consumer discretionary to see how they model for cyclicality.
My thoughts are that any cyclicality should be implicitly or explicitly captured in the average valuation multiple if you pick a reasonable time frame (3-5 years) though will caveat GFC has mostly distorted multiples due to low interest rates, - if you're looking at comparables company. If you're doing a dcf , because your time frame is at least 5 years, if you're not baking in cyclicality in, then you're doing something wrong. Macro cycles repeat every 3-7 years meaning there will always be an exogenous shock even if of MINOR degree - not all shocks are the same. And cylicality surfaces during bad times
Asset-based valuation? Multiples?
Typical approach is to find out mid-cycle earnings and slap a multiple on that.
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Learn moreMost of the time when valuing companies that are cyclical or have highly inconsistent earnings, we tend to use 'normalized' earnings and cash etc. Where do you put the normalized? It depends, while there are many cyclical companies, I would suggest reading investment write-ups and research reports on semi-conductor companies like Intel, NVIDEA, AMD, Qualcomm etc. These companies were my introduction to cyclical businesses, and since the semi-conductor space is highly coveted and covered, there will be a lot of models out there to try and understand. Start with these and learn what you apply to other businesses.
If in semiconductors I would be looking at DRAM/NAND and companies like Micron more than the ones you mentioned. For other real cyclicals, look at companies like AA, FCX or companies like transocean and golar LNG (you can really see how profitability, cash flow, working capital , and balance sheets flex through the cycles on these types of companies...
EDIT: oh and as others mentioned, they look cheap at the worst times and expensive at the best times to buy
Value a cyclical on a mid-cycle multiple. This is easier said than done.
Cyclical stocks can look and feel cheap at times of overvaluation, and conversely can feel uncomfortably expensive when they are in hindsight cheap. It is not uncommon for cyclical stocks to, in a full cycle, run 5-10x up and most of the way back down.
Personally, I also always put a good amount of weight on current earnings. Normalized earnings are not necessarily easy to judge, cycles can persist longer than people expect, and if you don't know what a company might earn in future years a good place to start is what they currently earn. It is not straightforward to determine market expectations. Try to explain the price action on homebuilder D R Horton (DHI) - stock went to $100 in late 2021 at the top of the post COVID housing boom, went back to $60 on higher interest rates crashing the market, and is now all the way back at $100 as if mortgage rates were still 2-3%.
Another useful valuation measure with cyclical stocks is physical volumes over enterprise value and/or market cap . Earnings can move all over the place but if you find two oil companies with equal barrels/day production and one is worth 2-3x the other, it probably warrants a look because these discrepancies can close over time or at least at points within the cycle. This is exactly the situation with Exxon as we speak - XOM is worth considerably more per barrel of oil (adjusted for cash flow generated from those barrels) than certain peers. The trick is to figure out why and an appropriate investment.
thx
Academically - multiple on midcycle earnings, but in practice it's all about catching the inflections (getting better -> getting worse) and playing for NTM revisions when/if the multiple isn't too ahead of the trend
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