One of the valuation metrics I look at when considering a share for my portfolio is its price-to-earnings (P/E) ratio. In general, the lower the P/E ratio, the cheaper a share may be. For example, at the moment the International Consolidated Airlines Group (LSE: IAG) share price is around seven times its annual earnings per share.
Such a single digit P/E ratio is often considered cheap. Easyjet has a P/E ratio of 11, for example, while Wizz Air is on a whizzier 19.
But does that P/E ratio really mean IAG is the sort of bargain share I would like to scoop up for my portfolio?
P/E ratios only tell one part of the story
While a P/E ratio can help when valuing a share, it only tells one part of the story. Another important thing for a would-be investor to do is look at the firm’s balance sheet.
It may be that a company has strong earnings but so much net debt that those earnings will end up being used to service it, not reward shareholders. Or, more rarely, a company may have a high P/E ratio but so much net cash that it is still a bargain.
IAG ended the first quarter with €6.1bn of net debt. That was €1.4bn less than at the same point last year, but is still substantial.
Future earnings could keep flying high – or not
Another factor to consider is the earnings themselves. The P/E ratio of 7 is based on last year’s earnings per share. But IAG’s earnings per share have moved around a lot over the past few years, in common with many of its rivals.
Last year’s diluted earnings per share were the best of the past five years. That period included two years when the company made a loss not a profit.
One way of looking at this is that the bad times are now in the past, with civil aviation demand having staged a strong recovery and IAG once again generating large profits.
It could be that that continues to be the case. IAG has well-known brands, strong positions in multiple European markets where it owns the flag carrier and has also been a ruthless cost-cutter over the years.
Although I think those are all assets that could help support the IAG share price, I do not see the inconsistent performance as a blip. Rather, I think that it reflects the risks inherent in operating an airline business — or investing in one.
Demand can come and go for all manner of reasons including external ones such as a pandemic, volcanic clouds, recession or terrorist attack. Meanwhile, airlines tend to be lumbered with sizeable fixed costs whatever is happening to passenger demand.
So while I think the IAG share price is a bargain based on current earnings, my concern is whether those earnings are sustainable over the medium- to long-term.
I’ve been bitten by airline shares before and am twice shy, so will not be buying IAG shares despite the seemingly cheap price.
