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An Intrinsic Calculation For American Airlines Group Inc. (NASDAQ:AAL) Suggests It's 45% Undervalued

Simply Wall St

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of American Airlines Group Inc. (NASDAQ:AAL) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for American Airlines Group

Is American Airlines Group fairly valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF ($, Millions) US$2.19b US$3.29b US$3.18b US$3.13b US$3.13b US$3.15b US$3.19b US$3.24b US$3.31b US$3.38b
Growth Rate Estimate Source Analyst x6 Analyst x3 Analyst x1 Est @ -1.41% Est @ -0.17% Est @ 0.7% Est @ 1.31% Est @ 1.74% Est @ 2.03% Est @ 2.24%
Present Value ($, Millions) Discounted @ 15% US$1.9k US$2.5k US$2.1k US$1.8k US$1.6k US$1.4k US$1.2k US$1.1k US$967 US$862

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$15b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (2.7%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 15%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$3.4b× (1 + 2.7%) ÷ 15%– 2.7%) = US$29b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$29b÷ ( 1 + 15%)10= US$7.4b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$23b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$28.6, the company appears quite undervalued at a 45% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

NasdaqGS:AAL Intrinsic value, November 19th 2019

The assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at American Airlines Group as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 15%, which is based on a levered beta of 2.000. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For American Airlines Group, I've put together three pertinent aspects you should look at:

  1. Financial Health: Does AAL have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does AAL's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
  3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of AAL? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.