November 28, 2014

Mail Bag (Two Parts) – Which Financial Ratios Would You Use to Value Airline Stocks?

A question about airline stocks and performing financial statement analysis on an airline company:

Mail Bag Question for Joshua KennonIf you were asked to perform a financial statement analysis for an airline what 5 ratios would you use and why are these the most relevant ones? – Pauline

I wouldn’t.  Airlines are notorious commodity-like businesses that require large capital expenditures and generate very little net cash flow adjusted for those outlays.  Even at a 5x price-to-earnings ratio, I’m not interested.  There are far easier ways to make money.  Humans have a tendency to want to value things that were difficult more highly than things that came easily, but $1 of profit spends exactly the same as another $1 of profit.  It doesn’t matter if that dollar were generated by a sewage treatment plant or a high-tech start-up.  

Pauline’s Response

Mail Bag Questions and Comments for Joshua KennonUnfortunately the prof asked us to perform a financial statement analysis for an ariline. The analysis is limited to only 5 ratios. We have to identify them then say why these are most relevant and important to the airline. I am struggle to answer this question but will try to figure it out. 

That’s too bad.  I once had a professor who wanted the same thing for Beta.  I refused to answer it and instead wrote an essay about why stock beta is a meaningless metric with the exception of short-term option pricing.  She gave me 108% on the exam, but not all professors are that rational.

I’m about to attend a regular get-together so if I leave anything out or don’t explain the basics sufficiently, I apologize.  

Profitability Ratios: I would take a form of “owner earnings”, which is net income + depreciation + amortization – capital expenditures necessary to maintain current volume – working capital requirements, adjusting for any underfunded pensions or contingent liabilities, and then divide it into average assets (beginning assets + ending assets / 2) and equity (beginning equity + ending equity / 2).  That gives you “Return on Owner Assets” and “Return on Owner Equity”, which I find more useful than plain vanilla Return on Assets (ROA) and Return on Equity (ROE).

Airline Industry Financial Ratios: Then, I’d look at the four industry-specific ratios for airlines, ASM, CASM, BELF, and RASM:

  • Available Seat Miles (ASM) = Amount of Seats to Passengers on All Flights x Number of Miles Those Seats Are Flown
  • Cost Per Available Seat Mile (CASM) = Adjusted Operating Expenses / Available Seat Miles (see above)
  • Break-Even Load Factor (BELF) = The total percentage of seats on an aircraft that need to be purchased for revenue to equal expenses, with the assumption that revenue per passenger mile and expenses remain constant.
  • Revenue Per Available Seat Mile (RASM) = Total passenger revenue divided by total available seat miles, expressed in cents.
You can read more about those metrics in this article from the Motley Fool.  The author does a good job explaining the basics.  None of my content covers the industry because, like I said, I think it’s a terrible business that requires a lot of smart people who are probably still going to fail to earn a decent return on capital.  I like businesses where even idiots drown in gushers of cash.  They’re much more fun.
 
I’d be obsessed with watching the regular liquidity metrics, too, especially the more aggressive ones such as the quick test ratio or acid test ratio.  Hope that helps.  Good luck with your work.
 
  • J

    I really enjoyed your humorous approach and comments on this article, thanks!

banner