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Cyclical stocks such as airlines and steel can appear to defy valuation. But an approach based on probability will help managers and investors draw up a reasonable estimate.
Companies in industries prone to significant swings in profitability present special difficulties for managers and investors trying to understand how they should be valued. In extreme cases, companies in these socalled cyclical industries-airline travel, chemicals, paper, and steel, for example-challenge the fundamental principles of valuation, particularly when their shares behave in ways that appear unrelated to the discounted value of their underlying cash flows.
We believe, however, that cyclical operations can be valued using a modified discounted-cash-flow (DCF) method similar to an approach used to value high-growth Internet start-ups.' First, though, we will explore the underlying relationships between the cash flows and share prices of cyclical companies, as well as the role securities analysts may well play in distorting market expectations of performance.
When theory and reality conflict
Suppose that you are using the DCF approach to value a cyclical company and have perfect foresight about its industry cycle. Would you expect the value of the company to fluctuate along with its earnings? The answer is no; the DCF value would exhibit much lower volatility than earnings or cash flow because DCF analysis reduces expected future cash flows to a single value. No individual year should have a major impact on the DCF value because high cash flows cancel out low ones. Only the long-term trend matters.
Company A, for example, has a business cycle of ten years and a highly volatile cash flow pattern that ranges from positive to negative (Exhibit 1, part 1). These cash flows can then be valued on the basis of the forecast from any one year forward. Discounting the free cash flows at 10 percent produces the DCF values in Exhibit 1, part 2. Exhibit 1, part 3, which brings together the cash flows and the DCF value (indexed for comparability), shows that the DCF value is far less volatile than the underlying cash flow Indeed, there is almost no volatility in the DCF value, because no single year's performance affects
it significantly.
In the real world, of course, the share prices of cyclical companies are less stable. Exhibit 2...