How to Value Airline Stocks

Airline stocks tend to resemble the state of the overall economy. When the economy is strong, airlines generate higher revenues as discretionary income increases and consumers chose to travel more. When the economy is soft, airlines have lower revenues as discretionary incomes are lower and consumers reduce their air travel.

But revenue is not the only driver of stock performance. Profitability moves these stocks too, as do factors such as fuel costs, foreign exchange rates, capital expenditures, and seat prices, which result in either margin expansion or contraction. Airline stocks are primarily valued based on these factors and valuation multiples.

Key Valuation Metric

The most common multiple used to value airlines is enterprise value (EV)-to-earnings before interest, taxes, depreciation, amortization, and rent (EBITDAR). The formula for EBITDAR is:

EBITDAR=EBITDA + Restructuring/Rental Costs

EBITDAR is a metric used primarily to analyze the financial health and performance of companies that have gone through restructuring within the past year. It is also used for businesses such as airlines that have unique rent costs of their aircraft fleet, warehouse, or other major assets used in the airline operations.

Excluding those mostly non-cash items from the valuation creates a more realistic and comparative operating profit measure.

Let’s use American Airlines (AAL) as an example. Here is the key financial information for American Airlines' year ending June 30, 2019.

The EV/EBITDAR with 2019 data would be 5.13 ($32.8 billion / $6.4 billion). Whether that number is good or bad will depend on where major peers trade and where AAL's EV/EBITDAR metric has trended in the past. For reference, AAL's EV/EBITDAR using 2018 data is 5.95 ($34.5 billion / $5.8 billion). Shares of AAL appeared more undervalued heading into 2020, versus the end of 2018.

Cash Flow

Free cash flow (FCF) is also used to value airline stocks given high fixed-cost structures and major capital expenditures (CapEx) are captured in this metric. Free cash flow is most simply calculated as operating cash flow minus capital expenditures (both figures can be found on the cash flow statement).

For AAL, it spent well more on CapEx in 2019 than it generated in operating income (which was negative for 2019), meaning it had negative free cash flow.

However, to use FCF to determine if a stock is a good value, FCF yield is computed. FCF yield compares the FCF to the market capitalization of the stock. AAL has not generated positive FCF since early 2017. Thus, using 2016 data, its free cash flow is $800 million ($6.5 billion in operating cash flow less the $5.7 billion spent on CapEx). Thus, its 2016 free cash flow was $800 million, putting its free cash flow yield at 3.3% ($800 million / $24.19 billion). For reference, Delta Air Lines (DAL) had an FCF yield of 10.9% for the year ended 2016.

FCF yield is a strong comparative measure. Assessing it relative to prior periods and a peer universe provides context for assessing the attractiveness of a stock and if it is under- or over-valued relative to the market and industry.

The Bottom Line

Both EV/EBITDAR and free cash flow (FCF) yield can be used to value airline stocks. These metrics, however, should not be used in isolation. Rather they should be compared to prior periods and to peers to determine a stock’s attractiveness.