Right now, the median historical P/E ratio of stocks in the FTSE 100 is 13.4. With City analysts forecasting average earnings growth of around 8.5% for the index’s constituents this year, the ratio is set to fall to 12.8 for 2020.
This is only the median valuation of stocks in the UK’s leading blue-chip index. Some businesses are worth substantially more or less. And one company that is worth considerably less is International Consolidated Airlines Group (LSE: IAG).
Impressive turnaround
Owner of the British Airways and Iberia brands, IAG is one of the world’s largest airline groups. Over the past 10 years, under the management of CEO Willie Walsh, IAG has been transformed from a money-losing basket case into a tremendously profitable airline business. Last year the company earned nearly €3bn, although this was mainly due to one-off factors. But City analysts are expecting a healthy €2.3bn of net profit for 2019.
Based on these figures, IAG’s return on equity — a measure of business profitability — was 32% last year, which puts the company in the top 10% of the most profitable public businesses on the London market.
However, despite these attractive profitability metrics, shares in IAG have the lowest valuation in the FTSE 100. At the time of writing, shares in the company are trading at a forward P/E of just 4.2, that’s a discount of 67% to the market average.
Generally speaking, companies with a higher level of profitability than the rest of the market deserve a premium valuation, but that’s clearly not the case with IAG. The question is why, and if it is worth taking advantage of this valuation anomaly?
Time to buy?
The airline business is quite an unpredictable one. There are so many different factors that can alter earnings. It is quite difficult to predict growth. Analysts have to take into account factors such as fuel costs, currency exchange rates, airport delays, interest rates and even the weather. There’s also the threat of strikes, which IAG currently has to contend with.
With so many things to consider, airline stocks tend to trade at a discount to the rest of the market because their growth outlook is so unpredictable. Shares in IAG have always been subject to this uncertainty discount, but it has never been as wide as it is today.
Historically, the stock has traded at a multiple of around eight times forward earnings. Based on current growth forecasts, this would imply a share price of 800p, an upside of 90% from current levels. IAG also looks undervalued compared to international peers. For example, the US airline sector trades at a forward P/E of around 7.
Undervalued
After taking into account IAG’s own valuation history, and the current valuation of its international peers, I have concluded that the stock is significantly undervalued at current levels. While the shares do deserve an uncertainty discount, a discount of around 40% to international peers seems too steep to me.
