Valuing Cyclical Companies
Cyclical businesses move with the economy or with commodity prices. Their earnings swing so widely that ordinary multiples mislead at both extremes.
Why this matters for beginners
At the top of a cycle, record earnings make shares look cheap. At the bottom, collapsed earnings make them look expensive. Both signals are inverted.
Main explanation
Cyclical industries include mining, shipping, semiconductors, airlines, construction and car manufacturing. Demand and prices are volatile by nature.
Because earnings peak with the cycle, a low multiple on peak earnings often means the market expects a decline, not that a bargain exists.
A better approach uses mid-cycle or average earnings across a full cycle, or asset-based measures for commodity producers.
Balance sheet strength matters more here than in stable industries, because survival through the downturn determines who benefits from the recovery.
Example using a real company
A miner earning 500 at peak commodity prices and 50 at the trough cannot be valued on either figure. An average across the cycle is more useful.
- →Peak earnings 500 at a multiple of 5 looks cheap but assumes prices hold.
- →Trough earnings 50 at a multiple of 40 looks expensive but may precede recovery.
Common beginner mistakes
- ✕Applying peak earnings multiples as if they were sustainable.
- ✕Ignoring debt levels going into a downturn.
- ✕Assuming a recent trend continues indefinitely.
Key terms
- Cyclical business
- A company whose earnings move strongly with economic or commodity cycles.
- Mid-cycle earnings
- Average earnings across a full cycle.
- Peak earnings
- The high point of earnings within a cycle.
Key takeaways
- 01Multiples on peak or trough earnings mislead.
- 02Use mid-cycle earnings for cyclical companies.
- 03Balance sheet strength decides who survives the trough.
Check yourself
- 01A low multiple on peak earnings can still indicate an expensive share.
- 02Current earnings are a reliable basis for valuing cyclical companies.
- 03Balance sheet strength matters more for cyclical businesses.
Try the concept on a real company
Open a cyclical company in the Analyzer and consider where in its cycle the current earnings figure sits.
Educational examples only. Not buy or sell recommendations.