How to Value Cyclical Stocks: Normalizing Earnings for Fair Value
Learn how to value cyclical stocks by normalizing earnings across business cycles, avoiding the trap of buying at peak earnings or selling at trough earnings.
Why cyclical stocks are hard to value
Cyclical companies -- those in industries like autos, steel, chemicals, and homebuilding -- see their earnings swing dramatically with the economic cycle. A low P/E ratio at peak earnings can be a sell signal, not a bargain, because earnings are about to fall. Conversely, a sky-high P/E at the trough may actually be the best time to buy, since earnings are depressed and poised to recover.
How to normalize earnings
- Average earnings over a full business cycle (typically 5-10 years) to smooth out peaks and troughs.
- Use mid-cycle revenue with a normalized profit margin based on historical averages.
- Compare the current stock price to normalized earnings rather than trailing twelve-month figures.
- Consider using price-to-book or EV/EBITDA as supplementary valuation anchors for asset-heavy cyclicals.
A cyclical stock with a P/E of 6 at the top of an earnings cycle can be more expensive than one with a P/E of 30 at the bottom. Always ask where you are in the cycle before relying on simple earnings multiples.
Screen for cyclical value
Use the screener to compare price-to-book and EV/EBITDA across cyclical sectors.
FAQs
Which sectors are considered cyclical?▼
Autos, steel, mining, chemicals, homebuilders, airlines, and semiconductors are classic cyclical industries. Their revenues and profits are closely tied to the broader economic cycle.
How many years should I average to normalize earnings?▼
A full business cycle, usually 5-10 years, captures both peaks and troughs. The Shiller CAPE ratio uses 10 years of inflation-adjusted earnings as its benchmark.
Related
Intrinsic Investor is for education and research only. Not financial advice.