Aviation stocks tend to be similar to overall economic conditions. When the economy is strong, as disposable income increases and consumers choose more travel, airlines generate higher income. When the economy is weak, airline revenue will decrease, because disposable income decreases and consumers reduce air travel.
But income is not the only driver of stock performance. Profitability will also affect these stocks. Factors such as fuel costs, foreign exchange rates, capital expenditures, and seat prices will also affect these stocks. These factors can cause profit margins to expand or contract. The valuation of airline stocks is mainly based on these factors and valuation multiples.
- The ratio of enterprise value to earnings before interest, tax, depreciation and amortization and rent (EV/EBITDAR) is the most common valuation multiple used to evaluate airlines.
- The analysis also uses free cash flow (FCF) yields to analyze airlines.
- These two indicators should not be used alone, but should be compared with previous periods or peers.
Key valuation indicators
The most common multiple used to assess airline value is the ratio of enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDAR). The high fixed costs of the aviation industry (related to owning and maintaining aircraft) result in large amounts of depreciation, amortization, and rental expenses. Excluding those mainly non-cash items from the valuation can create a more realistic and comparative measure of operating profit.
Let us take American Airlines (AAL) as an example. Below is the main financial information of American Airlines for the year ended June 30, 2019.
|American Airlines 2019 financial information||
The EV/EBITDAR for 2019 data will be 513 (US$32.8 billion/US$6.4 billion). Whether this number is good or bad will depend on the trading locations of major peers and the past trends of AAL’s EV/EBITDAR indicator. For reference, AAL’s EV/EBITDAR using 2018 data is 595 (US$34.5 billion/US$5.8 billion).Compared with the end of 2018, by 2020, AAL’s stock price seems to be even more undervalued.
Given the high fixed cost structure and major capital expenditures (CapEx) included in this indicator, free cash flow (FCF) is also used to evaluate airline stocks. Free cash flow is most simply calculated as operating cash flow minus capital expenditures (both figures can be found in the cash flow statement).
For AAL, its expenditure on capital expenditures in 2019 far exceeds the operating income it generates (negative in 2019), which means that its free cash flow is negative.
However, to use FCF to determine whether a stock has good value, you need to calculate the FCF rate of return. The FCF yield compares the FCF to the market value of the stock. Since the beginning of 2017, AAL has not produced a positive FCF. Therefore, using 2016 data, its free cash flow is US$800 million (US$6.5 billion in operating cash flow minus US$5.7 billion in capital expenditures). Therefore, its free cash flow in 2016 was US$800 million, and its free cash flow rate of return was 3.3% (US$800 million/US$24.19 billion). For reference, Delta Air Lines (DAL) has an FCF yield of 10.9% as of 2016.
The FCF rate of return is a powerful comparison indicator. The evaluation relative to the previous period and peers provides a background for evaluating the attractiveness of stocks and whether their value relative to the market and the industry is undervalued or overvalued.
Both EV/EBITDAR and free cash flow (FCF) yields can be used to evaluate airline stocks. However, these indicators should not be used in isolation. Instead, they should be compared with previous periods and peers to determine the attractiveness of the stock.