So how should a company such as Nordic American Tanker Ltd. (NAT) be valued? Because stocks are generally priced based on future expectations, beccause shipping companies don’t require annual maintenance capital expenditures (which is occasionally similar to depreciation and amortization for other industries), and because leverage can greatly increase earnings and share price volatility, crude tankers aren’t valued based on past price-to-earnings multiples.
To value Nordic—which could be used for other crude tankers—we used forward EV/EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization). Our research also shows that Nordic’s peers, such as Frontline Ltd. (FRO), Teekay Tankers Ltd. (TNK), and Tsakos Energy Navigation Ltd. (TNP), have traded at forward EV/EBITDA multiples of around ten times before 2011 for the most part, when industry profitability was high.
Valuation multiples change based on industry cycles. When margins (profitability) and profits are on the lower end, they lead to high valuation multiples (see the chart above). For a competitive, capital-intensive, and cyclical industry with relatively stable costs, booms and busts occur from time to time. But fundamentals often revert to the mean over the long run.
Fundamentals often go back to the average because if profitability is low, there’s little incentive for existing or new companies to increase supply and keep rates. Conversely, if profitability is on the higher end, like it was throughout 2005 to 2008, there’s higher risk that new vessels will be ordered to the extent rates will fall.
Impact on valuations
Because of this, industry troughs are often marked by peak valuations. The market is willing to value a company’s earnings higher in part because it’s just a matter of time for the industry to recover. Keep in mind that while higher valuations would be positive for share prices, lower EBITDA margins and EBITDA will more than offset the increase in valuations.
Note: Buying individual companies comes with risks unrelated to industry fundamentals. Investors who don’t understand such risks might want to consider the Guggenheim Shipping ETF (SEA), which invests in large shipping companies worldwide.
© 2013 Market Realist, Inc.
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