In Search of a Reasonable Airline P/E Ratio

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Price to earnings ratios are one of many measures for a company’s value. Simply put, it shows how many times earnings the market is willing to pay for a stock. However a reasonable P/E ratio varies by company and by industry. A rapidly growing start-up can trade at a four-digit P/E ratio for a period of time while a company in a low growth or shrinking space may trade for a P/E ratio in the single-digits. This article will examine the airline industry from a P/E perspective and try to give possible explanations for the variety of valuations.

A wild industry

Airlines are known for making some investors rich while wiping out others completely. It is an industry that has consumed billions of dollars and where high capital costs continue to attract investors who want to do what few others could. But even in this industry we have less exciting things like P/E ratios. Let’s take a look at them.

<table> <tbody> <tr> <td>Airline</td> <td>Current P/E</td> </tr> <tr> <td><strong>US Airways Group</strong> <span class="ticker" data-id="208435">(NYSE: <a href="">LCC</a>)</span></td> <td>5.5</td> </tr> <tr> <td><strong>Delta Air Lines</strong> <span class="ticker" data-id="210158">(NYSE: <a href="">DAL</a>)</span></td> <td>18.4</td> </tr> <tr> <td><strong>United Continental Holdings</strong> <span class="ticker" data-id="224520">(NYSE: <a href="">UAL</a>)</span></td> <td>N/A</td> </tr> </tbody> </table>

Among the three non-bankrupt major carriers we get quite a variety of P/E ratios. At one end, United Continental trades with a useless P/E ratio due to negative earnings and at the other end, US Airways trades for a lowly 5.5 times earnings. And in the middle, Delta trades for a P/E ratio in the upper teens.

However, there are explanations for this variety of numbers with some more clear than others. United Continental’s earnings were impacted by merger-related expenses stemming from the integration between United Airlines and Continental Airlines. US Airways' P/E ratio may be being kept down due to factors such as its smaller international network or uncertainty surrounding the merger with American Airlines, while Delta represents a completed airline merger and its P/E ratio could be setting a new normal in the industry. Or Delta could be trading more based on future earnings expectations.

The following table uses three different P/E ratios to approximate target prices. The current US Airways P/E ratio is the lowest, an approximation of a P/E of 10 is the second, and the current Delta P/E ratio is the final column.

<table> <tbody> <tr> <td>Airline</td> <td>2014 EPS estimate*</td> <td>P/E = 5.5</td> <td>PE = 10 </td> <td>P/E = 18.4</td> </tr> <tr> <td>US Airways Group </td> <td> $2.97</td> <td> $16.34</td> <td> $29.70</td> <td> $54.65</td> </tr> <tr> <td>Delta Air Lines</td> <td> $3.04</td> <td> $16.72</td> <td> $30.40</td> <td> $55.94</td> </tr> <tr> <td>United Continental Holdings</td> <td> $4.93</td> <td> $27.12</td> <td> $49.30</td> <td> $90.71</td> </tr> </tbody> </table>

Yahoo! Finance

Clearly the last column has very high estimates that are unlikely to be met. This is largely due to applying the current P/E ratio at Delta, even though the airline is probably trading at a premium to it current P/E ratio due to higher expected future earnings. Airlines tend to carry with them a greater investment risk which causes a lower valuation than a company with similar earnings growth in a more stable industry. For this reason, while I am bullish on the industry, I believe a P/E ratio of around 10 is a more acceptable valuation. But with projected earnings growth the way it is, this still leaves shares plenty of room to run in the next couple years.

US Airways throws an additional piece into the mix. While the merger with American Airlines should help in the realization of economies of scale and building a greater international presence in the long run, it is likely to impact near-term earnings with merger-related costs similar to what occurred at United Continental. Investors gave United Continental a break realizing these were one-time expenses but a lack of strong earnings to display could hurt the new American’s chances of moving higher based only on a P/E ratio. Investors will need to monitor the merger of US Airways and American to see how the integration plays out and how the market reacts.

Acceptable P/E

While Delta’s P/E ratio of 18.4 times represents that of an airline with a completed merger, it is likely that the market is partially valuing Delta on future earnings, which are expected to sharply rise. Therefore, an 18.4 times P/E ratio should not be expected for airline shares in the future. A more reasonable P/E ratio may be closer to 10, as an approximation. This would still leave airline shares plenty of room to run, and if the industry can grow earnings at the rate analyst estimates forecast, then an increase in the value of airlines would seem to be reasonable. As always, airlines are riskier investments, and those willing to accept risks are more likely to see the rewards. Personally, I have some shares and options on Delta and US Airways in the more speculative part of my portfolio. But potential investors should determine for themselves whether airline investments fit in a part of a broader investment strategy, and valuations for airlines are a good place to start.

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Alexander MacLennan owns shares of Air Canada and Delta Air Lines. He also owns the following options: long $22 Jan 2015 Delta calls, long $25 Jan 2015 Delta calls, long $30 Jan 2015 Delta calls, long $17 Jan 2015 US Airways calls. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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