At first glance, the valuation of British Airways’ parent company IAG (LSE:IAG) looks very cheap. IAG’s share price is less than four times last year’s earnings per share. A price-to-earnings ratio of less than four can certainly indicate that a company is in bargain territory.
Is this the case with IAG – and should I include it in my portfolio?
Very fluctuating returns
Although the P/E ratio was below four based on the previous year’s results, this reflected an unusually strong earnings performance at the airline. Basic earnings per share increased by more than six times compared to the previous year. In the two previous years, IAG had posted significant losses.
Variable revenue is an inherent part of the airline industry. Cost factors such as fuel prices can have a big impact but are generally outside of the airlines’ control. However, airlines can enter into contracts to mitigate the impact of sudden short-term price jumps. External events from volcanic eruptions to travel restrictions can cause sudden fluctuations in demand.
This year has started strongly for IAG. Earnings per share for the first six months were within 2% of the same period last year. For the full year, IAG expects strong travel demand in its core markets and significant free cash flow generation.
This means that not only is the historical P/E ratio low, but also the prospective P/E ratio, at least in the short term.
Improving the balance sheet
Profits are only one part of a company’s valuation. Expenditure obligations also play a role. Therefore, a company’s liquidity is important.
In its half-year results this month, IAG said it expected “maintain a strong balance sheet” for the rest of the year. I would hardly describe the balance as “strong“As of the interim reporting date, the company’s net debt amounted to EUR 6.4 billion.
Although this represents a high level of debt, it still represents a significant improvement over the halfway point of the previous year, when net debt was EUR 9.2 billion.
Due to recent developments, the company has been able to reduce its net debt, which I consider positive for the investment situation.
Is this a bargain?
So is IAG’s share price super cheap? First of all, debt is significant, so looking at the P/E ratio alone doesn’t tell the whole story. Still, earnings are strong and will remain so for the time being at least. With well-known brands, continued strong passenger demand and a lower cost base than before, IAG has some strengths as a company.
On the other hand, this lower cost base has in many ways come at the expense of the passenger experience. My own experiences with British Airways over the past few years have not increased, but decreased, my loyalty as a passenger.
Airline demand is highly unpredictable in the medium term because, as we have seen repeatedly, it can fall suddenly and without warning.
To consider the share price super cheap, I think you have to be confident that demand and revenue prospects will be good in the coming years. There is a risk that this will not be the case, so I am not so confident. I will not be buying IAG shares for my portfolio.
The post “IAG’s share price looks super cheap. Is it?” appeared first on The Motley Fool UK.
Further reading
C Ruane does not own any of the stocks mentioned. The Motley Fool UK does not own any of the stocks mentioned. The views expressed in this article about the companies mentioned in this article are those of the author and as such may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a diverse range of insights makes us better investors.
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