Understanding Cyclical and Commodity Companies
Welcome back to chapter 11 of the little book evaluation. In this chapter, the focus is on cyclical and commodity companies and the commonality they share. Both types of companies are heavily influenced by macroeconomic factors and must deal with the impact of economic cycles and fluctuations in commodity prices. This article will delve into the specific issues that arise when valuing and pricing these types of companies and explore potential solutions for addressing these challenges.
The Influence of Economic Cycle and Commodity Prices
Cyclical companies are particularly sensitive to the economic cycle. During a recession, these companies may struggle, while they thrive during periods of economic growth. On the other hand, commodity companies are heavily reliant on the price of the specific commodity they deal in. For example, an oil company will see its earnings rise when oil prices are high and decline when prices are low. Additionally, the finite nature of the resources involved in commodity companies means that perpetuity assumptions may be an overreach. For large oil companies, there is only a certain amount of oil in the ground, necessitating the use of a finite growth period in valuation models.
Impact on Valuation and Pricing
When valuing or pricing these companies, recent earnings numbers are heavily influenced by changes in commodity prices and economic growth. This leads to significant volatility in earnings and book value, greatly affecting the equity and debt values of the companies. As a result, a company's perceived safety or riskiness can fluctuate dramatically based on external macroeconomic forces.
Solutions for Valuation
To address the challenges posed by cyclical and commodity companies, alternative valuation methods may be necessary. Instead of relying solely on the most recent 12 months' numbers, averaging earnings over time can help mitigate the impact of cyclicality. By using average earnings and margins, normalization can be achieved without disregarding the size of the company.
Industry averages can also provide a benchmark for valuing particularly volatile companies, helping to establish target margins. Ultimately, the goal is to arrive at a valuation that reflects normalized earnings, not just the most recent figures that may be heavily influenced by external forces.
Case Study: Valuing Toyota and Royal Dutch Shell
To illustrate the application of these solutions, let's consider the valuation of Toyota and Royal Dutch Shell. In the case of Toyota, the use of average pre-tax operating margins over a longer period provided a more stable basis for valuation, normalizing based on the revenues at the time. This approach helped overcome the challenges of a particularly difficult year for the company.
In the case of Royal Dutch Shell, the impact of fluctuating oil prices was addressed by normalizing revenues based on the historical relationship between oil prices and revenues. This approach allowed for a valuation that was neutral to changes in oil prices, providing a more consistent and reliable assessment of the company's value.
Pricing and Comparisons
When it comes to pricing commodity companies, the use of multiple valuation metrics can yield differing results. Depending on the specific multiples employed, a company may appear undervalued or overvalued. It's important to consider the growth potential, risk factors, and the source of the commodity when comparing and pricing these companies.
Consideration of Optionality in Resource Companies
In the context of natural resource companies, particularly oil companies, the presence of nonviable reserves at current prices does not necessarily imply a lack of value. The optionality presented by the possibility of future changes in commodity prices must be factored into the valuation. This optionality is influenced by the amount of undeveloped reserves and the variance in commodity prices, adding a layer of complexity to the valuation process.
Conclusion
Valuing and pricing cyclical and commodity companies presents unique challenges due to their sensitivity to macroeconomic factors and commodity price fluctuations. By employing alternative valuation methods and considering the specific dynamics of the industry, a more accurate and consistent assessment of these companies' value can be achieved. Furthermore, taking into account the optionality inherent in natural resource companies enhances the completeness of the valuation. By understanding and addressing these complexities, investors and analysts can make more informed decisions when it comes to evaluating cyclical and commodity companies.
In conclusion, the valuation and pricing of cyclical and commodity companies require a thorough understanding of their dynamics and the use of specialized techniques to overcome the challenges they present.