Implications for Managing Cyclical Companies  731
would subtract the cost of purchasing natural gas (volume times natural-gas 
prices) and operating costs to estimate operating profits. It may be simpler, how-
ever, to model only volumes and the “crack spread”—the difference between 
polyethylene prices and the cost of natural gas—and then subtract operating 
costs. What ultimately matters is the crack spread, not the revenues. The crack 
spread will often be set by the demand–supply balance for polyethylene, not the 
level of natural-gas prices. For example, during a decline in natural-gas prices, 
the crack spread might remain constant as producers pass on the lower natural-
gas prices to customers by lowering polyethylene prices. If volumes were stable, 
so would be operating profits, despite a decline in revenues.4
Implications for Managing Cyclical Companies
Is there anything managers can do to reduce or take advantage of the cycli-
cality of their industry? Evidence suggests that, in many cyclical industries, 
the companies themselves are what drive cyclicality. Exhibit 37.6 shows the 
ROIC and net investment in commodity chemicals from 1980 to 2013. The 
chart shows that, collectively, commodity chemical companies invest large 
amounts when prices and returns are high. But since capacity comes on line in 
very large chunks, utilization plunges, and this places downward pressure on 
price and ROIC. The cyclical investment in capacity is the driver of the cyclical 
profitability. Fluctuations in demand from customers do not cause cyclicality 
in profits. Producer supply does.
Managers who have detailed information about their product markets 
should be able to do a better job than the financial market in figuring out the 
4 The analysis is more complicated than this example suggests, because some polyethylene producers 
use naphtha rather than natural gas as their raw material.
EXHIBIT 37.6  ROIC and Investment Rate: Commodity Chemicals, 1980–2013
Median of North American companies, %
Return on invested capital
Net investment rate,
3-year rolling average1
–10
0
10
–5
20
30
1995
1990
2000
2005
2010
2013
1980
1985
1 Change in net property, plant, and equipment adjusted for inflation.

732  Cyclical Companies
cycle and then take appropriate actions. We can only speculate why they do 
not do so. Still, based on conversations with these executives, we believe that 
the herding behavior is caused by three factors: First, it is easier to invest when 
prices are high, because that is when cash is available. Second, it is easier to 
get approval from boards of directors to invest when profits are high. Finally, 
executives are concerned about their rivals growing faster than themselves 
(investments are a way to maintain market share).
This behavior also sends confusing signals to the stock market. Expand-
ing when prices are high tells the financial market that the future looks great 
(often just before the cycle turns down). Signaling pessimism just before an 
upturn also confuses the market. Perhaps it should be no surprise that the 
stock market has difficulty valuing cyclical companies.
How could managers exploit their superior knowledge of the cycle? The 
most obvious action would be to improve the timing of capital spending. 
Companies could also pursue financial strategies, such as issuing shares at 
the peak of the cycle or repurchasing shares at the cycle’s trough. The most 
aggressive managers could take this one step further by adopting a trading 
approach, making acquisitions at the bottom of the cycle and selling assets at 
the top. Exhibit 37.7 shows the results of a simulation of optimal cycle timing. 
The typical company’s returns on investment could increase substantially.
Can companies really behave this way and invest against the cycle? It is ac-
tually very difficult for a company to take the contrarian view. The CEO must 
convince the board and the company’s bankers to expand when the industry 
outlook is gloomy and competitors are retrenching. In addition, the CEO has 
to hold back while competitors build at the top of the cycle. Breaking out of 
the cycle may be possible, but it is the rare CEO who can do it.
Summary
At first glance, the share prices of cyclical companies appear too volatile to be 
consistent with the DCF valuation approach. This chapter shows, however, 
that share price volatility can be explained by the uncertainty surrounding the 
industry cycle. Using scenarios and probabilities, managers and investors can 
take a systematic DCF approach to valuing and analyzing cyclical companies.
EXHIBIT 37.7  Relative Returns from Capital Expenditure Timing
Internal rate of return, %
4
5
9
34
Typical spending pattern
Spending evenly over cycle
Optimally timed capital spending
Optimally timed asset purchases