Want to buy shares of an automaker or an oil company? If you reply yes, then your valuation process will need to include the effects of economic and commodity cycles, as well as the basic business valuation.
In chapter 10 of "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," Aswath Damodaran looks under the hoods of companies with valuations that may be driven as much by external factors as by their own operational competence. Even mature companies in these sectors can produce volatile earnings and cash flows.
Two types of valuations are required, one for each of the sectors:
- Cyclical companies that rise and fall with overall economic conditions.
- Commodity companies that produce inputs to other, more complex products or have value as investments on their own (gold and diamonds, for example).
The valuations of both types of companies are affected by several common characteristics:
- Effects of the economic and commodity price cycles.
- Finite resources, meaning the availability of physical assets, and a condition that affects perpetual growth and terminal values.
- Distress, driven not by bad management decisions but by macroeconomic forces beyond management’s control.
In addition, operating income will change at a greater rate than the economic variables (commodity companies) or the state of the economy (cyclicals). Commodity companies, for example, have high fixed costs because they need to keep mines and agricultural fields open even during low points of the price cycle since it would be too expensive to shut down and then restart operations.
For intrinsic valuations, this means greater volatility in earnings, which will then affect both equity and debt values, and leads to changes in the cost of capital. Damodaran argued the same dynamic holds for relative valuations as multiples of earnings will swing from one extreme to another. Growth rates are also subject to big changes over the course of a cycle.
This points to the need for averaging and, according to Damodaran, there are three standard procedures for “normalizing” earnings and cash flows:
- Absolute averages over time: The most common technique, and should include enough years to cover a typical economic cycle (five to 10 years).
- Relative averages over time: This involves using a scaled version of a variable over time; for example, average the profit margin over time, rather than actual profits.
- Sector averages: Dealing with a company with a limited or unreliable history? Use sector averages, but beware because this approach fails to account for a company’s differences from the sector.
To illustrate, Damodaran did a valuation of Toyota (TM, Financial) in early 2009; at the time, it had the reputation of being the best-run automaker, but was still susceptible to global economic forces. In the last quarter of 2008 it reported a loss, and later would report a loss for its fiscal year (April 2008 to March 2009).
To get a normalized operating income, he applied the average pretax operating margin of 7.33% to its trailing 12-month revenues of 226,613 billion yen ($2.02 trillion) (Normalized operating income: 226,613 * 0.0733 = 1,660.7 billion yen).
Getting to a valuation of the equity involved several steps:
- Assuming Toyota has a stable growth rate of 1.5% and a return on capital of 5.09%, it had net operating assets of 19,640 billion yen (formula not available).
- Add the value of cash: 2,228 billion yen.
- Add cross holdings: 6,845 billion yen.
- Subtract debt: 11,862 billion yen.
- Subtract minority interests: 583 billion yen.
Using those assumptions and data, total equity would have been 16,268 billion yen. Dividing it by 3.448 billion shares produced a valuation per share of 4,735 yen, which was 54% above the share price at the time of 3,060 yen.
Turning to commodities, such as oil or gold, Damodaran said there are two ways of establishing normalized prices:
- The average price of the commodity over time, adjusted for inflation.
- Determining a fair price for the commodity, given its demand and supply.
With normalized prices, an analyst can estimate what revenues, earnings and cash flows would have been. As Damodaran noted, though, a normalized price does inject personal and corporate assumptions into the analysis.
On the other hand, an analyst might use market-based prices, based on forward and futures markets; this approach also allows for hedging. To do this, an investor would buy shares of an oil company and also sell oil price futures for protection.
Relative valuation: The author wrote the two basic approaches used for the discounted flow (intrinsic) approach also work in relative valuations. Those two approaches were using normalized earnings or adapting the growth rate.
For example, in comparing Petrobras (PBR, Financial) and Exxon Mobil (XOM, Financial), he argued the two companies should trade at different multiples, even though they are similarly affected by the price of oil, because the earnings of Petrobras are riskier. At the same time, Petrobras would have higher growth potential.
Further, the multiples of cyclical and commodity companies will change as they move through cycles. At the peak, multiples will bottom out. At the bottom of the cycle, the multiples will top out.
Some investors become uncomfortable when valuation does not consider the interrelationship between a commodity price and the investment and financing actions of commodity companies. For example, some oil companies can produce more oil when prices are high, allowing them to return more cash to shareholders. Thus, these companies have “options” which can be exercised according to the price of oil.
Summing up, in chapter 10 of "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," Damodaran provided systematic and objective ways to assess companies affected by economic and commodity cycles.
The author: Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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