Valuing Cyclical Stocks: The Mid-Cycle EBITDA Rule.
Why buying a cheap-looking steel or cement stock at the peak can destroy your hard-earned savings.
Ramesh sat at his Thane shop, watching the stock of his main steel supplier hit a record high. Profits had tripled. The shares looked cheap. He invested his savings, confident the boom would last. A year later, steel prices crashed, and his hard-earned money halved.
Some businesses do not grow in a straight line. Steel mills, cement plants, and car makers go through wild seasons of boom and bust. When the economy is strong, they make massive profits. When demand cools down, their earnings can drop to zero, or they might even run into heavy losses.
Investors often make the mistake of buying these cyclical stocks when they look cheapest. At the top of a boom, a company's profits are huge, which makes its price-to-earnings ratio look very low. But this is a trap. You are paying a price based on peak profits that cannot last.
To value these businesses safely, we must look at their normalized earnings. We take the average operating profit, or EBITDA, over a full seven to ten-year cycle. This is called mid-cycle EBITDA. It represents what the business can reliably earn on average, through both good times and bad times.
By multiplying this mid-cycle profit by a conservative, historical multiple, we find the real worth of the business. This simple step keeps us from overpaying during the euphoric booms and gives us the courage to buy when the industry is suffering a downturn.
The Mood-Swinging Neighbour
Imagine a neighbor who offers to sell you his business. On sunny days, when customers line up, he demands a high price but points out that the daily profit is excellent. On rainy days, when no one visits, he gets depressed and offers to sell it for a pittance. Mr. Market is that mood-swinging neighbor. If you value his business only by looking at his best days, you will overpay. You must look at his average earnings over a whole year of seasons to know the real value.
Why this matters
Your hard-earned savings are too precious to lose to market cycles. When you buy cyclical stocks based on peak profits, you are taking a massive risk with your portfolio. Using mid-cycle EBITDA is like checking a house's foundation before buying, rather than just looking at the fresh paint. It ensures you invest with a safety cushion, protecting your capital from sudden sector crashes.
Where people go wrong
- Buying at low P/E during the boom peakAt the peak, profits are temporarily bloated. This makes the P/E ratio look deceptively cheap just before earnings crash.
- Extrapolating a single blockbuster yearAssuming that peak commodity prices will last forever leads to overestimating the company's long-term value.
- Ignoring high debt levelsCyclical companies with high debt often go bankrupt during down cycles because they cannot cover interest costs when profits drop.
Cyclical profits swing wildly; never value them based on a single blockbuster year's peak earnings.
Use a 7-to-10 year average EBITDA to calculate a safe mid-cycle valuation for these stocks.
Low P/E ratios at the top of an economic cycle are almost always a dangerous valuation trap.
We suffer from recency bias. When steel or cement prices are high, we assume the sun will shine forever, forgetting that every winter is followed by a cold, quiet spring.