Numbers can lie -- yet they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:
- The current price multiples.
- The consistency of past earnings and cash flow.
- The amount of growth we can expect.
Let's see what those numbers can tell us about how expensive or cheap Southwest Airlines
The current price multiples
First, we'll look at most investors' favorite metric: the price-to-earnings ratio. It divides the company's share price by its earnings per share (EPS). The lower the P/E, the better.
Then we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This tool divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). As with the P/E, the lower this number is, the better.
Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.
Southwest Airlines has a P/E ratio of 19.1 and an EV/FCF ratio of 7.4 over the trailing 12 months. If we stretch and compare current valuations with the five-year averages for earnings and free cash flow, we see that Southwest Airlines has a P/E ratio of 23.3 and a five-year EV/FCF ratio of 47.9.
A one-year ratio of less than 10 for both metrics is ideal. For a five-year metric, less than 20 is ideal.
Southwest Airlines has a mixed performance in hitting the ideal targets, but let's see how it stacks up against some of its competitors and industry mates.
Delta Air Lines
Source: Capital IQ, a division of Standard & Poor's; NM = not meaningful.
Numerically, we've seen how Southwest Airlines' valuation rates on both an absolute and relative basis. Next, let's examine …
The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash-flow generation.
In the past five years, Southwest Airlines' net income margin has ranged from 1.0% to 6.5%. In that same time frame, unlevered free cash flow margin has ranged from -21.6% to 15.8%.
How do those figures compare with those of the company's peers? See for yourself:
Source: Capital IQ, a division of Standard & Poor's; margin ranges are combined.
In addition, over the past five years, Southwest Airlines has tallied up five years of positive earnings and four years of positive free cash flow.
Next, let's figure out …
How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks. But even though you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared with similar numbers from a company's closest rivals.
Let's start by seeing what this company's done over the past five years. In that time period, Southwest Airlines has put up past EPS growth rates of 0.3%. Meanwhile, Wall Street's analysts expect future growth rates of 8.3%.
Here's how Southwest Airlines compares with its peers for trailing five-year growth. (Note that Delta, JetBlue, and AMR all had losses that rendered their trailing growth rates meaningless):
Source: Capital IQ, a division of Standard & Poor's; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years:
Source: Capital IQ, a division of Standard & Poor's; estimates for EPS growth.
The bottom line
The pile of numbers we've plowed through has shown us the price multiples that shares of Southwest Airlines are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.
The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 19.1 P/E ratio, and we see numbers that look good compared with its peers but not as good in absolute terms. But this is just a start. If you find Southwest Airlines' numbers or story compelling, don't stop here. Continue your due-diligence process until you're confident that the initial numbers aren't lying to you.
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Anand Chokkavelu doesn't own shares in any company mentioned. Southwest Airlines is a Motley Fool Stock Advisor choice. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.