Despite climbing 105% in five years, International Consolidated Airlines Group (LSE:IAG) shares trade at a price-to-earnings (P/E) multiple of 9. That’s well below the FTSE 100 average of 17.
It’s also well below the multiple the stock traded at a year ago, which was 21. So is this a huge opportunity, or is something else going on?
Operational leverage
Nearly every business goes through ups and downs, but some more so than others. And airlines are some of the most volatile when it comes to earnings. The biggest costs are fuel, staff, airport fees, and aircraft. And importantly, these are the same whether a plane is 99% full or 60% empty.
That can be great when things are going well. Being able to add more customers with almost no extra cost means almost all the revenue from ticket sales converts to profits. Equally though, earnings can evaporate quickly when demand drops and airlines end up flying fewer passengers at no real reduction in costs. And IAG’s P/E multiple is a reflection of this.
In general, the P/E ratio a stock trades at doesn’t actually tell investors much about how cheap it is. What it does say, is what the market’s expecting from the underlying business.
When a stock trades at a high multiple, it’s a sign investors are anticipating growth. Equally, a low P/E ratio is a good indication that investors think there might be difficult times ahead.
Turbulence ahead?
IAG shares trading at a P/E ratio of 9 means investors think this are about as likely as they’re going to get, at least for now. But it’s worth noting analysts don’t seem to agree.
Earnings per share are forecast to increase from 46p in 2024 to 71p over the next three years. If that happens, the stock’s trading at a P/E multiple of around 4 based on 2028 earnings.
| Year | (Anticipated) EPS | Implied P/E Ratio |
|---|---|---|
| 2024 | 47p | 6.32 |
| 2025 | 53p | 5.6 |
| 2026 | 58p | 5.12 |
| 2027 | 64p | 4.64 |
| 2028 | 71p | 4.18 |
For my part though, I’m on the side of the market. I think there are a couple of reasons why investing based on an expectation of steady profit growth over the next few years is quite risky.
One is the possibility of a recession. The UK is IAG’s largest market and I think the chance of Britain entering an economic downturn in the near future is unusually high right now. Another is the risk of one-off events, such as the recent fire at Heathrow. The financial impact on IAG’s unclear, but it reminds me of the IT outage in 2017 that cost the firm £80m.
To some extent, all businesses face exogenous threats. But the risk is greater for companies with high fixed costs – such as IAG – where the impact on profits is more profound.
April opportunity?
Other things being equal, it’s better to buy shares at a lower earnings multiple than a higher one. But with cyclical businesses like IAG, other things aren’t equal.
Heading into April, a lot has been going right for IAG. But this is when the risks are greatest and investors need to be most wary. I think that’s what a low P/E multiple is – rightly – reflecting.
There are a few FTSE 100 stocks I’m looking to buy this month, but IAG isn’t one of them.
This post was originally published on Motley Fool
