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30-06-2023, 08:14 AM
As a fundamental investor, one of your key task is valuing companies. This poses a challenge when you value cyclical companies.
There are 2 perspectives of cyclical companies
I would like to focus on the latter. According to Damodaran, when you are project the earnings of cyclical companies, you should not extrapolate them based on the recent performance. Rather you should look at the earnings over the cycle. This is because of its up and down pattern, the performance over the cycle will give a more representative picture of its long term performance.
I will illustrate this with Vulcan Materials. This is a US construction aggregates Group. The US aggregates demand (tonnage) is cyclical as there is a strong correlation with the US Housing Starts .
Notwithstanding its good results over the past few years, VMC’s performance over the cycle is poor. There was no shipment tonnage growth. Revenue growth was due to price increases.
![[Image: Vulcan.png]](https://i.postimg.cc/436C8nHR/Vulcan.png)
Gross profit margins and SGA margins were cyclical with no improvement trends. Revenue and equity growths were low despite the acquisitions. Its reinvestment rate is not sustainable.
Given this, when valuing VMC, I used the cyclical earnings as the key input. A valuation of VMC based on its cyclical performance shows that it is currently overvalued.
You can get the market if you assumed that it is not cyclical and is a high-growth stock. The market is assuming that the recent performance represents the future whereas a cyclical lens showed that this is not the case.
So the question is should you ignore the cycle and assumed that it will grow from here or do you take a conservative approach and see that what goes up must come down.
I have an article that discuss what to do when analysis cyclical companies in greater detail. Refer to How to overcome issues when valuing cyclical companies
There are 2 perspectives of cyclical companies
- it is cyclical from the price perspective
- it is cyclical from the business perspective
I would like to focus on the latter. According to Damodaran, when you are project the earnings of cyclical companies, you should not extrapolate them based on the recent performance. Rather you should look at the earnings over the cycle. This is because of its up and down pattern, the performance over the cycle will give a more representative picture of its long term performance.
I will illustrate this with Vulcan Materials. This is a US construction aggregates Group. The US aggregates demand (tonnage) is cyclical as there is a strong correlation with the US Housing Starts .
Notwithstanding its good results over the past few years, VMC’s performance over the cycle is poor. There was no shipment tonnage growth. Revenue growth was due to price increases.
Gross profit margins and SGA margins were cyclical with no improvement trends. Revenue and equity growths were low despite the acquisitions. Its reinvestment rate is not sustainable.
Given this, when valuing VMC, I used the cyclical earnings as the key input. A valuation of VMC based on its cyclical performance shows that it is currently overvalued.
You can get the market if you assumed that it is not cyclical and is a high-growth stock. The market is assuming that the recent performance represents the future whereas a cyclical lens showed that this is not the case.
So the question is should you ignore the cycle and assumed that it will grow from here or do you take a conservative approach and see that what goes up must come down.
I have an article that discuss what to do when analysis cyclical companies in greater detail. Refer to How to overcome issues when valuing cyclical companies