It is evident from practice that in cyclical industries (aircraft, iron, paper, chemicals, real estate…) organizations periodically create excess capacity and cycle the industry.
When selling prices are attractively high, business inertia takes over. At this time, all competitors are moving at high speed, and even rational executives find it difficult to convince shareholders that creating more production capacity is wrong. As a result, excessive investments are made, supply exceeds demand, and the motivation to utilize capacity leads to the necessity of lowering prices.
It should be noted that in such industries, despite large fluctuations in EPS, stock market prices remain relatively stable. This means the market is aware of the cyclical phenomenon and does not symmetrically follow temporary profitability fluctuations.
From a valuation perspective, when using the DCF method, it is essential to consider the effect of cyclicality. Seeing at what stage the organization is at is crucial. Valuations made in different years should not depend on the profitability of a specific year.
The most challenging aspect of evaluating cyclical companies is determining whether the current peak is a cycle peak or a new development trend. Has a new development stage started in the life of a specific organization?
McKinsey advises creating two cash flow scenarios, one assuming the organization has transitioned to a new, higher development trend and the other assuming the trend has not changed. These two scenarios should then be weighted 50/50. This advice is based on historical research data.
Source:
Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels
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