Valuing Cyclical Stocks Assigning intrinsic value to businesses with unsteady earnings

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 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 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.  Below is a chart of the earnings history for the car manufacturer for the past ten years:

Thinking back to the early 90's, 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 has ever seen.  The successive climb in profits in 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% decline in profits over the course of the year.]

The most recent annual results indicate that profits had fallen abysmally; reported 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 companies that was affected.

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 on the average earnings of a cyclical business for the past ten years.  Historically, this time frame has covered an entire business cycle, allowing for a clear view of the drastic fluctuation in profits.

Had an investor valued GM in 1999 when earnings per-share were $8.53, they would have likely paid many times what the company was worth.  Instead, they should have based their 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. 

That Isn't All
In General Motors' case, even the "average" earnings may be too high an estimate of future profits.  Considering the unprecedented bull market that was present during most of the 1990's, it is hard to believe that such high 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, a valuation based on $4.66 in average earnings may still be too much.

Copyright © 2002 Joshua Kennon