What’s the Best Approach for Valuing American Airlines?

In this part of the series, we’ll look at the following three methods you can use to value AAL:

• forward PE (price-to-earnings)
• forward EV-to-EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization)
• forward EV + Op. (operating) leases-to-EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent)

A forward PE ratio is calculated by dividing a company’s current stock price by the earnings estimate for the next 12 months. The major advantage of a PE ratio is that it’s easy to calculate and thus very widely used.

However, one of the major drawbacks of a PE ratio is that EPS (earnings per share) is subject to distortions from differences in capital structures and accounting rules. Also, earnings are highly prone to manipulations. With a forward PE ratio, an added disadvantage is errors related to analyst estimates.

Despite these disadvantages, most market participants track a company’s earnings and use PE ratio, usually for first-level analysis. That’s why it’s important to keep a track of this ratio.

For a capital-intensive industry such as airlines, we use an EV-to-EBITDA ratio, because companies often end up taking varying levels of debt. EV-to-EBITDA is a capital-structure-neutral ratio. It takes both equity and debt capital into account. Using this ratio allows us to compare companies with various debt levels.

For airlines such as American Airlines (AAL), we go a step further. Airlines often use operating leases to buy aircraft, resulting in huge rents paid. To neutralize this, we use the EV+ Op. leases-to-EBITDAR ratio to value airline companies. We use the forward EV+ Op. leases-to-EBITDAR multiple. A forward multiple uses the next 12-month estimate.

You can gain coverage to airline stocks by investing in the iShares Transportation Average (IYT), which holds 4.2% in Alaska Air (ALK), 3.9% in United Continental (UAL), 3.8% in Southwest Airlines (LUV), 3.6% in Delta Air Lines (DAL), 2.8% in American Airlines (AAL), and 1.7% in JetBlue Airways (JBLU).

In the next and final part of our series, we’ll see how American Airlines’ valuation has changed over the years.