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, and 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 impact valuation multiples.

Valuation Metrics

The most common multiple used to value airlines is enterprise value (EV) to earnings before interest, taxes, depreciation, amortization, and rent (EV/EBITDAR). This industry’s high fixed costs (related to owning and maintaining airplanes) result in significant depreciation, amortization and rent expenses. Excluding those mostly non-cash items from the valuation creates a more realistic and comparative operating profit measure. Let’s use the case of American Airlines Group, Inc. (NYSE: AAL) Q1 2015 financials as an example. EV can be calculated from the company’s financial statements, but it is often readily available from most financial websites.

1Q 2015 Data

In $Billions



Revenue



6.369



Operating Income less D&A and Airplane Rent



5.148



EBITDAR



1.221


EV 43.66

Source: Yahoo! Finance

If we extrapolate the EBITDAR out for the full year (while it is an unrealistic assumption that all four quarters will have the same EBITDAR, for this hypothetical calculation, we will assume it to be true), the EBITDAR would be $4.884 billion and EV/EBITDAR for 2015 would come to 8.9x.

Cash Flow Analysis

Free cash flow (FCF) is also looked at because high fixed cost structures and major capital expenditures (necessary for these businesses) are captured in this metric. Free cash flow is most simply calculated as operating cash flow minus capital expenditure (both figures can be found on the cash flow statement). FCF for AAL for the three months ending March 31, 2015:

AAL Statement of Cashflows

                                            $2.285 million-$1.160 million =$1.125 million

AAL had FCF of $1.125 million as of March 31, 2015. This compares to $20 million for the prior year's quarter, a tremendous increase. To use FCF to determine if the stock is a good value, FCF yield is computed. FCF yield compares the FCF to the market capitalization of the stock. AAL’s FCF yield for the three months ending March 2015:

                                            $1.125B/34.42B=3.3%

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 and used in trend analysis to determine a stock’s attractiveness. Furthermore, any one particular company's financial position and past performance should be measured with respect to its closest competitors and the industry as a whole.