Module II· DCF — Mechanics & FCFAdvanced

Question

Why does a 'standard DCF' typically undervalue cyclical companies?

Answer

Mechanics

A standard DCF often projects off the most recent figures — which, for cyclical companies, represent either a cyclical peak or trough. Two failures:

If you start at the trough: the forecast extrapolates the weakness, the terminal year is 'normalized' too low — valuation too low.
If you start at the peak: the forecast extrapolates for too long, the terminal year is not normalized enough — valuation too high. Fix: use mid-cycle earnings (a 10-year average of margins) in the terminal year, NOT trailing twelve months.

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Pitch tip

For cyclical targets like steel or autos, a DCF is weaker than mid-cycle comps; in an interview: 'For cyclical targets I would rely primarily on mid-cycle comps, using a DCF only as a cross-check with explicitly normalized margins.'

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