Why the PE Ratio Isn’t A Good Way to Value A Cyclical Company

circle of competence Cyclical shares tend to rise and fall with the respective business cycle or economy. Some cyclical companies are businesses in the discretionary spending sector, things that the consumer can and will cut back on during times of economic downturn. These include companies such as Singapore Airlines (SGX: C6L), FJ Benjamin (SGX: F10), Epicentre (SGX: 5MQ) and Hour Glass (SGX: E5P). This is because when economy is doing well, people can afford to travel more, buy more clothes, iPads, and luxury watches. Conversely, when the economy is not doing well, consumers tend to cut back on discretionary expenditure. Property developers such as Keppel Land  (SGX: K17) and Yanlord Land (SGX: Z25) can also be considered as cyclical companies. The demand for a private property tends to be in high when the economy is doing well and relatively poor during a recession.

Some investors try to buy into such companies during a business downturn and sell them when the upturn comes. A common method of valuing companies is using the price to earnings ratio (P/E Ratio). For example, United Overseas Bank (SGX: U11), is currently trading at SGD 20.10 per share and has earned SGD 1.72 per share last year. If we divided the two numbers, we can see that UOB is currently trading at a P/E ratio of 11.6. Comparing this with the P/E ratio of other companies, we can get a sense of the value of UOB relatively to its peers.

So why is the P/E ratio not a good gauge for valuing of such companies? This is because when the company is facing a down cycle, there are little or no earnings. This will result in a  high P/E ratio. On the other hand, when the company is doing well and having record earnings, the company will then trade at a very low P/E ratio due to the outsized earnings. This is the oxymoron of cyclical investing.

Foolish Takeaway

A tool will only make the job of the practitioner easier but it can never do the job for him. It is important to know that P/E ratio is a great tool for us to understand the valuation of a company, but it should be used together with the understanding of the long term fundamental of a business and the risks and opportunities that lie ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.