American Airlines Group Inc (NASDAQ: AAL) trades at a P/E multiple of 10.8x, which is lower than the Industrials sector median of 22.8x. While this makes AAL appear like a stock to add to your portfolio, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Understanding Valuation Multiples and the P/E Ratio
A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (peer group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Multiple is a valuation ratio that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Multiple = Stock Price ÷ Earnings Per Share
The P/E ratio is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different. I compare American’s P/E multiple to those of Delta Air Lines, Inc. (NYSE: DAL), United Continental Holdings, Inc. (NYSE: UAL), Southwest Airlines Company (NYSE: LUV) and Alaska Air Group, Inc. (NYSE: ALK) in the chart below.
Since American’s P/E of 10.8x is higher than the median of its peers (8.9x), it means that investors are paying more than they should for each dollar of AAL’s earnings. As such, our analysis shows that AAL represents an overvalued stock. In fact, finbox.io’s P/E Multiple Modelcalculates a fair value of roughly $36.00 per share which implies approximately 14.5% downside.
Note that the selected multiple of 9.2x in the analysis above was determined by averaging American’s current P/E multiple with its peer group.
Understanding the P/E Ratio’s Limitations
Before jumping to the conclusion that American should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to American, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare American with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
Now if the second assumption does not hold true, American’s higher multiple may be because firms in our peer group are being undervalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to AAL. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on American by taking a look at the following:
Valuation Metrics: what is American’s free cash flow yield and how does it compare to its publicly traded peers? This metric measures the amount of free cash flow for each dollar of equity (market capitalization). Analyze the free cash flow yield here.
Risk Metrics: what is American’s cash ratio which is used to assess a company’s short-term liquidity. View the company’s cash ratio here.
Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View American’s return on equity here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.