Valuation Ratios in the Airline Industry

8/10/2019 Valuation Ratios in the Airline Industry

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Valuation Ratios in the AirlineIndustry

John PagazaniTara Trussell

Roisin Byrne



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Objectives

We want to determine the following: – Valuation ratios to use for the airline industry – Key factors which influence these ratios – How to intuitively match a given airline with a

set of valuation ratios based on its strategy



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Airline Industry Valuations

To start, let’s review the background on theindustry and the companies in question...



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Airline Industry Overview

A i r l i n e

t r a f f i c

1978 1998

A i r l i n e

f a r e s50% farereduction Triple

airtraffic



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Porter’s Five Forces for theAirline Industry

National-InternationalCarriers Regional Carriers

Competitive Rivalry

6 main players -

STRONG

Many players -

STRONG

Threat of NewEntrants

Hub carrier domination -WEAK

Low cost jet aircraft,new markets - STRONG

Threat of SubstituteProducts

Air travel necessity -MODERATE

Air travel necessity -MODERATE

Buyer Power Price sensitive -

STRONGPrice sensitive -

STRONG

Supplier Power Full pricing control ofkey inputs - STRONG

Full pricing control ofmost key inputs -

STRONG



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Overview of the Airlines to beAnalyzed



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Delta Air Lines

Background• Long haul carrier• Founded as the world’s first crop -dusting service in 1924.• Established its domestic network via other regional carrier acquisitions – highly

competitive market.• In 1991, Delta entered the international markets.• Largest U.S. airline in terms of aircraft departures and number of passengers

served, third largest in terms of operating revenue• Labor issues in 2000 – unionized workforce

Strategy• Variety of services – Delta Shuttle, Delta Express, Delta Connection, International

alliances• Not a clearly defined strategy except to offer services to everyone



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Sky West Airlines

Background• Regional carrier• Founded in 1972, Sky West operates 108 aircraft from 6 hubs• Over 1000 daily departures to 68 destinations• 70% of flights were jointly coded with Delta Air lines and United Airlines flights

• Compete with other regional airlines, low-fare carriers and larger airlines.• Strong relationship with non-unionized workforce

Strategy• High quality customer service• Joint affiliations which reduced reliance on any single major airline code

• Operations are enhanced and stabilized through a combination of Sky Westcontrolled and contract flying.• Committed to acquire 113 additional regional jets with operations on another 119

aircraft – dependant largely on contracts with Delta and United.



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Southwest Airlines

Background• Hybrid carrier• Founded in 1971 with three Boeing 737, Southwest operates 344 aircraft and

services 57 destinations• Focused on frequent flights to conveniently located and less congested airports• Wait time at airport gates is less than half the industry average• Operates only one type of aircraft

Strategy• Cost leader in the industry• “no frills service” at a low price • High asset utilization and tight control over operating expenses.• No code-sharing relationships with other airlines• Simple fare structure – low unrestricted coach fares• Majority owned by its employees - Strong relationships with non-unionized

workforce



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How do we value these airlines?

Now that we have some background on theindustry and the airlines, let’s look at theratios we can use to rank them in terms ofvalue…



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Determinants of Price-Earnings(PE) Ratio

PE = f(earnings growth – cost of equity capital)• A firm with a HIGH PE ratio is expected to exhibit HIGH

earnings growth (over and above costs and inflation.)• A firm with a LOW PE ratio will not exhibit earnings above

the current level of earnings (approx. = rate of inflation. pluscosts)



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Determinants of Return on

Equity (ROE)ROE = f(Dupont relationships)= f(NI/Sales X Sales/Assets X Assets/SE)= f(Profit margin + asset turnover + leverage)= Earnings/equity



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Determinants of Price-to-Book

(PB) RatioPB = f[future abnormal ROE + growth in

equity(book value) – cost of equity capital]• A firm with a HIGH PB ratio is expected to grow and

expand its asset base over and above the CEC• A firm with a LOW PB ratio is not expected to grow

beyond the rate of inflation



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Relationship between the Ratios

Once we determine one of the ratios, theothers can be solved because they are linked

by return on stockholders’ equity (ROE):

PE (price/earnings) x ROE (earnings/equity) =PB (price/equity)



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Interpretation of the Ratios

PE PB ROE Interpretation

"Rising" H H H

- Expectations of high earnings growth relative to recent earnings (high P/E)- Earnings growth will increase the asset base (high P/B)- Both will contribute to rising ROE

"Recovering" H L L- The firm will recover from recently lower earnings (high P/E)- Will not exhibit growth in asset base (low P/B)- Will not exhibit high returns (low ROE)

"Falling" L H H

- The firm will not grow earnings beyong current levels (low P/E)- High earnings expected on current investments (high P/B & high ROE)- New investment returns at lower levels (low ROE)

Takeover or"bankruptcy"

L L L- The firm will experience earnings growth (high P/E)- Will not exhibit growth in asset base (low P/B)- Below average returns are expected (low ROE)



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The Four Airlines

Now, let’s take our knowledge of how theratios work and apply them to what weknow about the airlines…



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Summary of the AirlinesIndustry Delta American Skywest Southwest

ROE 12% 17% 12% 18% 21%

ROE trend

Cost of equity capital 12.50% 12.5% 12.5% 12.5% 12.5%

Net operating margin 6% 5% 9% 11%

Net operating margin trend

Price / book 2.0

Price / book trend

Price / earnings - ' ve

Price / earnings trend

Asset growth (5 yr) 12.4% 6% 20.1% 15.4%

Revenue growth (5 yr) 6.1% 3% 16.1% 14.5%

2001 2002 2001 2002 2001 2002 2002 2003 2001 2002

Air traffic growth 3.5%

Air traffic growth trend

Yield (avg revenue per passenger) 4%

Revenue growth 8% > 30% > 30% 11% 12%

Earnings growth loss moderate

increase loss profit 32% 22% 19% 24%

ROE 8.0% 8.5% ~ 23% ~ 23% 17% 17.5%

Industry

A i r l i n e s

I n d u s t r y

A n a

l y s

t p r e d

i c t i o n s

H i s t o r i c a

l

5 ( y r )

SouthwestSkywestAmericanDelta

2 0 0 1



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Exercise: Identify the Airlines

Airline Price/Earnings (PE) Price/Book Value (PB)A = ? 7.5 0.8B = ? 6.8 1.2C = ? 16.8 3.1D = ? 26.8 4.9

• We do not have adequate information to precisely CALCULATE the ratios, so we

want to use our intuition to gauge whichairline best fits each description below:



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Possible Results and Discussion

Airline Price/Earnings (PE) Price/Book Value (PB) A = American 7.5 0.8 B = Delta 6.8 1.2 C = Skywest? 16.8 3.1 D = Southwest? 26.8 4.9

• American = High competition for routes, low historical ROE, low PEas earnings growth not over CEC, PB <1 since ROE < CEC

• Delta = High competition for routes, average historical ROE, ROE >CEC, so PB >1, low PE

• Southwest = flexible, non-union labour, low cost strategy sustainable,high PB, high PE due to presumably sustainable long-term earningsgrowth

• Skywest = Serves larger air carriers who can also compete directly,depends on Delta/United for business ~ maybe earnings not assustainable, high ROE, ROE > CEC = PB much greater than one, PE ishigh also, but limited sustainability



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Summary

We have seen that by a) reviewing thestrategies and b) estimating the direction andmagnitude of earnings and asset base growth,we can intuitively rank airline companiesusing our PE and PB valuation multiples.

Valuation Ratios in the Airline Industry

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