Introduction

Bull markets have a reliable way of making expensive stocks look cheap. When earnings are at their peak and sentiment is strong, headline valuation multiples compress — and investors mistake cyclical prosperity for permanent earning power. This is one of the most common and costly errors in equity investing.

The antidote is not pessimism. It is cycle-aware valuation — the discipline of assessing a company’s worth based on normalised, through-the-cycle earnings rather than whatever the most recent quarter happens to show.

1. The Problem with Peak Earnings Valuation

When a company is enjoying peak profitability — driven by low input costs, strong pricing power, or a short-term demand tailwind — its reported earnings are at their highest. A low P/E ratio at this point is misleading. The denominator is inflated, making the stock appear cheaper than it actually is on a sustainable basis.

This is the recency bias trap. Investors extrapolate recent strong earnings into the future, assign a higher growth multiple to justify the optimism, and end up double-counting the positives — once in the elevated earnings base and again in the premium multiple applied to it.

As Howard Marks observed, virtually everything in markets is cyclical. High margins, high return on equity, and favourable working capital cycles all revert to the mean over time. No industry is exempt — airlines, refining, FMCG, cement, and auto ancillaries have all demonstrated this pattern across market cycles.

Investor implication: Before acting on a low P/E, ask whether the earnings driving that multiple are representative of the business across a full cycle — or whether you are valuing a temporary peak as though it were permanent.

2. Cross-Cyclical Valuation: The Right Framework

The appropriate valuation framework for cyclical businesses is one that normalises earnings across a full business cycle — accounting for both the good years and the difficult ones. This is sometimes referred to as cross-cyclical or normalised earnings analysis.

For capital-intensive businesses such as infrastructure, telecom, or port companies, standard DCF or P/E analysis based on recent cash flows can be particularly misleading. When a company has completed a large capital expenditure cycle, near-term free cash flow may look poor — but future cash flows to shareholders can be substantially higher once the investment phase is behind them. Penalising such companies purely on historical free cash flow track record misprices their forward opportunity.

Conversely, companies in cyclical downturns — pharmaceuticals under margin pressure, banks in a peak provisioning cycle — may appear expensive on trailing multiples. But the elevated P/E or P/B ratio reflects depressed earnings in the denominator, not an overvalued business. On normalised earnings, these companies may be far more reasonably priced than they appear.

Investor implication: Apply different valuation lenses to different business situations. A single trailing multiple, read in isolation, tells you where a company is in its cycle — not what it is worth.

3. Where the Opportunity Actually Lies

The logical consequence of cycle-aware valuation is a clear investment principle: the most attractive opportunities tend to cluster in businesses at cyclical lows, not cyclical highs.

At the bottom of a cycle, the market discounts these companies severely — pricing in continued deterioration rather than eventual normalisation. This creates a gap between current market price and normalised intrinsic value that a patient investor can exploit. The eventual mean reversion in margins, working capital, and earnings growth then drives returns that are disproportionate to the apparent risk at purchase.

The mirror image of this is equally important. Companies trading at peak earnings and peak multiples simultaneously offer the worst risk-reward in the market. The margin of safety is negative — any normalisation in either earnings or sentiment compresses returns, often sharply.

Investor implication: Spend more time studying businesses at cyclical lows that trade cheap on normalised earnings. Be willing to reduce or exit positions in businesses trading at peak margins and premium multiples — regardless of how strong the recent narrative feels.

The Bottom Line

Valuation discipline in a bull market is harder than it sounds — because peak earnings generate peak confidence, and peak confidence generates peak prices. The investor who mistakes a cyclical earnings high for a structural earnings level will consistently overpay, and the eventual mean reversion will make the error obvious in hindsight.

Buy businesses when the cycle is against them and the valuation reflects it. Sell — or at minimum reassess — when the cycle is with them and the market has priced in perfection. This asymmetry is where long-term returns are built.

At MoneyWorks4Me, our stock research incorporates normalised valuation analysis — helping investors distinguish between genuinely cheap businesses and those that only appear cheap at the top of their earnings cycle. Make valuation decisions grounded in the full picture, not just the latest quarter.