Why Cyclical Stocks Can Have Their Lowest P/E Ratios at Peak Earnings
A low P/E ratio in a cyclical stock may conceal peak earnings. Learn to assess the cycle by separating price and earnings timing, normalized margins, investment needs, and debt obligations.
Cyclical stocks can have low PERs as earnings surge during booms and high PERs as earnings fall during downturns. If the share price anticipates an earnings slowdown, strong recent results can paradoxically make the stock look cheaper. Look beyond a single year’s multiple to earnings across several cycle phases and the current business structure.
Share prices and historical earnings reflect different points in time
Earnings over the latest four quarters may still reflect earlier high selling prices and utilization rates. The share price, meanwhile, may already reflect weaker new orders or expected supply increases. The numerator falls while the denominator remains elevated, lowering PER further. In the opposite phase, the price may reflect recovery expectations before earnings improve, causing PER to jump. This is why interpreting a low PER as an automatic buy signal and a high PER as an automatic sign of overheating often fails in cyclical industries.
Normalize using both historical averages and the current structure
Collect revenue and margin data covering booms and downturns, then check for changes in production capacity, product mix, and cost structure. Applying only an old average of net income to a company whose facilities have doubled can miss its current scale. You can also consider applying an appropriate normalized return to revenue or invested capital. Conversely, removing every downturn from the analysis effectively labels peak results as normal. Explain what price, volume, and cost levels would make your normalized earnings estimate achievable.
Align investment and debt with the cycle as well as earnings
Not all the cash generated in a boom is available for dividends. It may fund capacity expansion and inventory, or increase the fixed-cost burden in the next downturn. Raising earnings to normalized levels while retaining depressed downturn capital expenditure can overstate cash flow. Consider supply expansion schedules, lags in contract pricing, and debt maturities together, and calculate the impact of a delayed recovery. Using PBR or EV/EBITDA as supplementary measures does not eliminate issues involving asset impairments, depreciation and amortization, or maintenance investment.
Worked example
Hypothetical example: At a boom-time share price of KRW 30,000 and EPS of KRW 6,000, PER is 5x. If the price later falls 20% to KRW 24,000 while EPS declines to KRW 2,000, PER rises to 12x. If normalized EPS based on several historical cycle phases and current facilities is estimated at KRW 3,000, the normalized PERs at the two prices are 10x and 8x, respectively. Normalized EPS itself is an assumption to validate, rather than a settled figure.
What to check
- Does the PER denominator still reflect boom-time prices and utilization?
- Do normalized earnings reflect both booms and downturns and the current facility base?
- Have you adjusted reinvestment and debt obligations alongside earnings normalization?
- Have you checked the cash available to withstand a delayed recovery?
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.