Disclaimer: This is not investment advice, just one person’s opinion. Always complete thorough analysis on your own before investing and understand the risks associated with an investment as you could lose it all.
The focus of this article will be to show how I compare companies to potentially invest in them. I will walk you through how I begin a fundamental analysis of a company’s financials. Before we begin, I will use a lot of jargon and financial ratios, so please check out the vocabulary section at the bottom of the article for definitions.
In this analysis I wanted to look at the airline industry since many users on Invstr have taken advantage of its incredible rise in the past few weeks. Some airlines have even retraced 50%. After large moves like this, it is important to reassess whether or not you want to hold that stock. To develop this analysis I chose Delta, Southwest, United, American, Alaska Air, Jetblue, and Spirit. I began by importing balance sheet and income statement data. I then created two tables to compare these companies: one in regard to valuation and another looking at quality.
The valuation table uses trailing 12 month price to earnings ratio (p/e ratio), enterprise value (EV)/sales, EV/EBIT, and EV/EBITDA. The end result of these ratios is to gauge the relative price of the companies compared to their earnings. The quality table looks at debt:equity, leverage, coverage, quick ratio, EBITDA margin, return on assets (ROA), and sales growth. Debt:equity, leverage, and coverage attempt to look at the financial well-being of companies by analyzing their debt levels. The quick ratio looks at cash and cash-like assets relative to upcoming liabilities. EBITDA margin, ROA, and sales growth look at how profitable and efficient these firms are.
Based on just the ratios, and keeping in mind a post-Covid world, I like Delta the best. In my opinion Delta is far superior. All of Delta’s valuation ratios are below average, meaning that it is relatively cheaper than other major airlines. Delta has below average debt levels and has a low interest expense relative to earnings. Delta’s profitability and return on assets are among the best. This combination of lower than average valuation and strong quality numbers make it my favorite by far; and I really believe that Delta is undervalued. My least favorite is American. American has very poor quality ratios overall. Specifically, American has a lot of debt, and interest expense, with a lower than average, relative earnings. In a period of time where investors are going with quality, I would stay away from American. While there have been days where stocks like American out-perform, I think the general trend will be quality for the near term. One thing to keep in mind is that if good news about the virus comes out, American will likely move up more than its peers because with such high debt levels, positive news provides a larger relief than its peers with less risky debt levels receive.
Airlines like United, Alaska and Jetblue have slightly above average valuation ratios but each have their pitfalls in quality. On average these airlines are likely slightly relatively overvalued to their peers, or relatively fair-valued. American has low valuation ratios but has low quality ratios, highest risk but hopefully high reward. While Spirit has a mixed bag of multiples, overall I do like Spirit based on just looking at ratios. Spirit has higher debt, but strong profitability and very high growth. Southwest is relatively expensive, but it makes up for it by having some of the highest quality ratios. Southwest is a safe pick, but it is important to keep in mind that it does have the highest earnings multiples. If I were to rank them from best to worst I would have Delta, Southwest, Spirit, Alaska, United, Jetblue, and American.
A potential trading idea for Invstr would be to hold the top three or four airlines (see disclaimer above). Another could be a pairs trade, to hold the top two and short the bottom two. I personally like pairs because in a market volatility regime like this it is tough to predict general directional moves. When you buy one and short another, market moves do not impact your returns, only relative out-performance or relative under-performance does. That being said, I predict that companies with stronger ratios will out-perform those that have worse ratios.
While using financial ratios to value and compare companies is considered “good” practice among finance professionals, it is important to remember there are limitations to ratios. There is a lot of external information that goes into the value of a company in addition to ratios. And much more can affect the future performance of a stock. As mentioned previously, ratios also do not take into account past growth, company vision, or expected growth. All of which can contribute to high valuation ratios. This analysis leaves out almost all non-ratio information, which if I were to invest in a company I would absolutely consider. Leaving this out allows for an easier demonstration of a comparable analysis of airlines.
Stay tuned for more industry analyses. And follow my Invstr page @robbieb for trading ideas and commentary on events in financial markets.
Vocabulary:
P/E: Stock Price/Earnings per share. Measures how much you are paying for a dollar of earnings.
EBIT: Earnings before interest and taxes.
EBITDA: Earnings before interest, taxes, depreciation, and amortization.
Enterprise value (EV): market capitalization + preferred equity + minority interest + total debt – cash
EV ratios (EV/sales, EV/EBIT, and EV/EBITDA): Measures how much a company earns relative to the total value of the firm.
Debt:equity: Ratio of how much debt financing a company uses compared to equity.
Leverage (Debt/EBITDA): Measures debt relative to earnings.
Coverage (Interest expense/EBITDA): Measures how many times a company can cover its interest expense with the most recent earnings.
Quick ratio: (link to article)
EBITDA margin (EBITDA/sales): Measure of profitability.
ROA (Net income/Average total assets): Return on assets measures how profitable a company’s assets are at producing revenue.
