Valuing Cyclical and Commodity Companies#

You find a steel company trading at 4x earnings. A bargain? Maybe. Or maybe earnings are at a cyclical peak, and the stock is actually expensive. Cyclical companies are valuation minefields—they look cheapest at the top and most expensive at the bottom.

Understanding Business Cycles#

Cyclical vs. Defensive Industries#

Cyclical companies see 50-100%+ swings in earnings through the cycle. Defensive companies might vary 10-20%.

The Earnings Cycle Pattern#

The Trap: At the peak, P/E looks compelling (e.g., 5x). But earnings are about to collapse.

Normalized Earnings: The Key Concept#

Normalized earnings estimate what a company would earn in a "normal" or mid-cycle year—smoothing out peaks and troughs.

Methods to Calculate Normalized Earnings#

Method 1: Historical Average

Take average EPS over a full cycle (7-10 years):

If current EPS is $7.00 (peak) and P/E is 6x, stock trades at $42. But on normalized earnings: $42 / $3.81 = 11x normalized P/E.

11x is much more expensive than 6x suggested.

Method 2: Mid-Cycle Margins

Apply average margins to current revenue:

Normalized Earnings = Current Revenue × Average Operating Margin × (1 - Tax Rate)

Example: Steel Company

• Current Revenue: $5B
• Average Operating Margin (10 years): 8%
• Current Operating Margin: 15% (peak)
• Tax Rate: 25%

Normalized EBIT = $5B × 8% = $400M
Normalized Net Income = $400M × (1 - 0.25) = $300M

Current Net Income = $5B × 15% × 0.75 = $562M

Using current earnings overstates sustainable profitability by 87%.

Method 3: Replacement Cost Analysis

For commodity producers, calculate:

Normalized Earnings = Production Volume × Long-Run Average Price × Average Cost Structure

This assumes commodity prices revert to long-term averages.

Mid-Cycle Valuation Framework#

Step 1: Identify Where We Are in the Cycle#

Step 2: Calculate Normalized Metrics#

For cyclical comparison:

• Normalized EPS
• Normalized EBITDA
• Normalized margins

Step 3: Apply Mid-Cycle Multiples#

Compare to what companies traded at during "normal" periods:

A steel company at 5x current (peak) earnings but 10x normalized earnings trades at mid-cycle valuation.

Commodity Company Specifics#

Valuation Metrics for Resource Companies#

Example: Mining Company Valuation#

GoldCorp Metrics:

• Proven gold reserves: 10 million ounces
• Annual production: 500,000 ounces
• Production cost: $1,000/oz
• Current gold price: $2,000/oz
• Enterprise Value: $8 billion

Key Ratios:

EV/Reserves = $8B / 10M oz = $800/oz
EV/Production = $8B / 500K oz = $16,000/oz
Current Margin = $2,000 - $1,000 = $1,000/oz profit

Reserve Life: 10M / 0.5M = 20 years Simple Valuation: 500K oz × $1,000 × 20 years = $10B undiscounted value

Commodity Price Scenarios#

Always run sensitivity on commodity prices:

Small commodity price changes have outsized effects on profitability and value.

Common Cyclical Valuation Mistakes#

1. Buying "Cheap" P/E at Cycle Peaks#

A P/E of 4x screams "buy"—until earnings collapse 70% and P/E jumps to 15x.

Fix: Always calculate normalized P/E alongside current P/E.

2. Selling "Expensive" P/E at Cycle Troughs#

P/E of 30x (or negative) looks terrible—but earnings are depressed.

Fix: If normalized P/E is reasonable and balance sheet is strong, the stock may be attractive.

3. Using Current Margins for DCF#

Projecting current peak margins forever dramatically overstates value.

Fix: Use normalized margins or explicit margin mean-reversion in projections.

4. Ignoring Balance Sheet Strength#

Cyclical companies need strong balance sheets to survive downturns.

Checklist:

• Net debt / EBITDA < 2x (at mid-cycle earnings)
• Interest coverage > 4x (at trough)
• Cash to cover 12+ months operations
• No near-term debt maturities

5. Assuming "This Time Is Different"#

Every cycle peak comes with narratives for why high profits will persist:

• "China demand is structural"
• "Supply is constrained forever"
• "New technology changes everything"

These narratives are usually wrong. Prices and margins mean-revert.

Putting It Together: Valuation Checklist#

For Cyclical Companies:#

1. Where in the cycle? Early, mid, late, recession?
2. Normalized earnings? Average over 7-10 years or mid-cycle margins
3. Normalized P/E? Compare to historical mid-cycle multiples
4. Balance sheet strength? Can it survive the downturn?
5. Margin of safety? Buy well below normalized value to protect against being wrong on timing

For Commodity Producers:#

1. Reserve life and quality? How long can they produce?
2. Cost curve position? Low-cost producers survive downturns
3. Commodity price sensitivity? Model bear, base, bull scenarios
4. Replacement cost? What would it cost to build this from scratch?
5. NAV discount? Most miners trade at 0.6-0.8x NAV