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 so-called 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.1 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...