Valuation Ratios in the Airline

Industry
John Pagazani
Tara Trussell
Roisin Byrne

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

Airline Industry Valuations

To start, lets review the background on the
industry and the companies in question...

Airline fares

50% fare
reduction

Airline traffic

Airline Industry Overview

1978

1998

Triple
air
traffic

Porters Five Forces for the

Airline Industry
Competitive Rivalry
Threat of New
Entrants
Threat of Substitute
Products
Buyer Power

Supplier Power

National-International
Carriers
6 main players STRONG

Regional Carriers
Many players STRONG

Hub carrier domination - Low cost jet aircraft,

WEAK
new markets - STRONG
Air travel necessity Air travel necessity MODERATE
MODERATE
Price sensitive Price sensitive STRONG
STRONG
Full pricing control of
Full pricing control of
most key inputs key inputs - STRONG
STRONG

Overview of the Airlines to be

Analyzed

American Airlines
Background
Long haul carrier
Established in the 1920s, American was one of the first U.S. giants in the industry
due to >80 acquisitions, and the largest U.S. airline based on revenues in 2000
Owns two regional airlines and also one of the largest airfreight carriers in the
world
Very competitive domestic market with up to nine airlines providing service on
competitive routes.
Strategy
Pricing decisions largely affected by competition some with lower cost structure
Efficient and quiet aircraft
In 2000, American Eagle regional jet fleet was increasingly aggressive
Continued expansion into domestic and international route networks anchored by
efficient hubs, enabled American to capitalize on any passenger traffic growth

Delta Air Lines

Background
Long haul carrier
Founded as the worlds 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

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 West
controlled and contract flying.
Committed to acquire 113 additional regional jets with operations on another 119
aircraft dependant largely on contracts with Delta and United.

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 the
industry and the airlines, lets look at the
ratios we can use to rank them in terms of
value

11

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. plus
costs)

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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

13

Determinants of Price-to-Book
(PB) Ratio
PB = 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, the
others 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

"Rising"

"Recovering"

"Falling"

Takeover or
"bankruptcy"

PB

ROE

Interpretation

- 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

- 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)

- 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)

- 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, lets take our knowledge of how the
ratios work and apply them to what we
know about the airlines

17

Summary of the Airlines

Industry

Delta

American

Skywest

Southwest

12%

17%

12%

18%

21%

12.50%

12.5%

12.5%

12.5%

12.5%

6%

5%

9%

11%

Asset growth (5 yr)

12.4%

6%

20.1%

15.4%

Revenue growth (5 yr)

6.1%

3%

16.1%

14.5%

ROE
ROE trend
Cost of equity capital

2001

Historical

Net operating margin

Net operating margin trend
Price / book

2.0

Price / book trend

Price / earnings

- ' ve

5 (yr)

Price / earnings trend

Industry

Industry

2002

American

2001

2002

loss

moderate
increase

2001

Skywest

Southwest

2002

2002

2003

2001

2002

8%

> 30%

> 30%

11%

12%

profit

32%

22%

19%

24%

8.5%

~ 23%

~ 23%

17%

17.5%

3.5%

Air traffic growth trend

Yield (avg revenue per passenger)

Airlines

Analyst predictions

2001
Air traffic growth

Delta

4%

Revenue growth
Earnings growth
ROE

8.0%

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loss

Exercise: Identify the Airlines

We do not have adequate information to
precisely CALCULATE the ratios, so we
want to use our intuition to gauge which
airline best fits each description below:
Airline
A=?
B=?
C=?
D=?

Price/Earnings (PE)
7.5
6.8
16.8
26.8

19

Price/Book Value (PB)

0.8
1.2
3.1
4.9

Possible Results and Discussion

American = High competition for routes, low historical ROE, low PE
as 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 earnings
growth
Skywest = Serves larger air carriers who can also compete directly,
depends on Delta/United for business ~ maybe earnings not as
sustainable, high ROE, ROE > CEC = PB much greater than one, PE is
high also, but limited sustainability

A=
B=
C=
D=

Airline
American
Delta
Skywest?
Southwest?

Price/Earnings (PE)
7.5
6.8
16.8
26.8

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Price/Book Value (PB)

0.8
1.2
3.1
4.9

Summary
We have seen that by a) reviewing the
strategies and b) estimating the direction and
magnitude of earnings and asset base growth,
we can intuitively rank airline companies
using our PE and PB valuation multiples.

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