As the world's third biggest airline company, Delta Air Lines (NYSE:DAL) plays a major role in the portfolios of many airline investors. But since the airline put out its full-year 2013 earnings earlier this year, many market commentators have used one valuation point in a misleading way.

So while I still believe Delta's current valuation makes it undervalued, one metric exaggerates this undervaluation, which results from a one-time event.

Tax gains
Many news sites now report that Delta trades at only 3.2 times earnings even as the airline industry trades closer to 15 times earnings. That's true, but investors need to read beyond the price-to-earnings ratio. When examined more closely, it becomes clear that $8 billion out of Delta's $10.5 billion profit for 2013 came from a non-cash tax gain. Once the one-time tax gain is excluded, Delta's adjusted price-to-earnings ratio is just over 13, much closer to the industry average.

This gain came as Delta decided to fully value its deferred tax asset, or DTA. When companies lose money like Delta did during the recession, they can use the losses incurred against future profits thereby reducing their tax bill once the company is profitable again. In Delta's case, its DTA is quite valuable, as it will allow the airline to avoid billions in future taxes.

So why did Delta assign a value to its DTA only for 2013? Because a DTA is valuable only if the company expects to produce a profit, therefore allowing corporate taxes to be cancelled out by the DTA. Strong performance for 2013 assured Delta officials that future profits are to be expected, so it made sense to fully value the DTA.

Such moves for recovering companies with large prior losses are common. For example, Fannie Mae reported a $59 billion profit for a single quarter in 2013 because of the revaluation of its DTA, and Freddie Mac reported a $30 billion profit a few months later because of its own DTA revaluation.

Going forward

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Photo: Makaristos. Licensed under public domain via Wikimedia Commons.

So was Delta's accounting department trying to pull a fast one on investors? No. Such moves are common in corporate accounting, and Delta was even kind enough to spell it out in its press release.

But this move does mean a few things for investors. The first is that the unadjusted 2013 P/E ratio shouldn't be used to value the airline. Rather, investors should look at forward earnings and cash flows to value Delta's stock.

The second part is that investors should note that although Delta won't have to pay any corporate taxes for at least the next few years because of its DTA, it will report earnings as if these taxes were being paid. Delta noted in its 2013 earnings press release that "net income will be reduced to reflect a 39% tax rate" for future earnings.

For upcoming reports and future projections, investors should look at the airline's cash flow to get the best picture for how much money Delta has available for things such as capital expenditures, debt reduction, dividends, and share buybacks.

Does this make Delta overvalued?
When investors factor in a 39% tax rate on future income, current analyst estimates have Delta trading at less than 13 times FY 2014 earnings and less than 11 times FY 2015 earnings. This valuation is below that of the S&P 500, which trades at around 16 times forward earnings, although slightly higher than United Continental and American Airlines Group. However, I believe this premium is warranted since Delta has worked on positioning itself as a less risky airline by slashing debt and taking on fewer capital expenditure obligations than its major airline peers.

The cash-flow side also looks positive, with Delta trading at 6.6 times FY 2014 operating cash flow and 5.9 times FY 2015 operating cash flow. But what's especially important for Delta investors is the airline's generation of free cash flow.

In a June presentation, Delta targeted $3 billion in annual free cash flow in its five year plan. If Delta's targets are correct, the airline trades around 13 times this free cash flow level for a 7.7% cash yield. In this area, Delta has the advantage over its two largest rivals. United Continental is not posting profits as high as Delta, and American Airlines Group is directing its cash flow toward a massive fleet overhaul. The extra free cash flow at Delta comes largely from the airline's approach toward its fleet, involving keeping older aircraft and being more selective in new aircraft orders.

With its free cash flow advantage over rivals, investors can look for more debt reduction, dividends, and stock buybacks than from United Continental and American Airlines Group.

Is it a buy?
Airline stocks remain above average in risk because of economic and energy cost risks, but Delta has come a long way toward becoming a safer investment. The airline cut adjusted net debt by over $9 billion since 2009 to sit at $7.6 billion as of its last earnings report. Not only does this reduce interest expense, but it should also help the airline borrow on more favorable terms if necessary in the future.

The airline has also made moves to return capital to shareholders by becoming the first legacy airline to reinstate a dividend, and by launching a $2 billion share-buyback program. With Delta at its current valuation and these shareholder-friendly initiatives in place, I remain bullish on the airline's shares.

Alexander MacLennan owns shares of AMERICAN AIRLINES GROUP INC, Delta Air Lines, Fannie Mae, and Freddie Mac. Alexander MacLennan has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, long January 2015 $30 calls on Delta Air Lines, long January 2015 $17 calls on AMERICAN AIRLINES GROUP INC, long January 2015 $32 calls on AMERICAN AIRLINES GROUP INC, and long January 2015 $40 calls on AMERICAN AIRLINES GROUP INC. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.