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Valuing cyclical companies

• Companies in cyclical industries—such as airlines and chemicals that are prone to swings in profitability—present a challenge in terms of valuation. A modified discount-cash-flow (DCF) method may help.
• Though consensus earnings forecasts are often linked to market value, they tend to show an upward trend and ignore cyclicality altogether. One analysis of cyclical companies reveals that consensus forecasts do not predict—or even acknowledge—earnings cycles.
• Because companies can move in and out of cycles, the market cannot predict cycles with utter accuracy. A middle path between 50 percent perfect foresight and 50 percent zero foresight may be a reasonable expectation for the market.
• Managers and investors can benefit by using a probabilistic approach to valuation that explores a range of outcomes and implications. Managers of companies in cyclical industries can also learn to exploit their knowledge of the industry in question and benefit from cyclicality.