At a P/E ratio of 4, are IAG shares a bargain?

The average price-to-earnings (P/E) ratio for FTSE 100 stocks is 12. By comparison, shares in International Consolidated Airlines Group (LSE:IAG) look like a bargain at 4 times earnings. 

A look at the company’s financial situation gives a different impression though. With £14bn in total debt, the stock’s more expensive than it looks. 

Enterprise value

International Consolidated Airlines has a market-cap of around £9bn. But the true cost to investors who buy the shares today is likely to be around twice that.

The company has £14bn in total debt. With £4.75bn in cash on its balance sheet, that leaves  £9.2bn for investors to factor into their thinking.

International Consolidated Airlines Group Total Debt 2014-24

Created at TradingView

Paying this back will be expensive for shareholders. It might come from earnings – which could otherwise have been paid out as dividends – or IAG might ask investors to buy extra shares.

Factoring in this cost means the current share price probably represents a P/E ratio of around 9.5. That’s still lower than the FTSE 100 average, but it’s much closer.

Capital intensity and competition

The stock might not be the bargain it initially appears to be. But a P/E ratio of 9.5 isn’t hugely expensive for shares in a business with attractive economics and a strong competitive position.

Unfortunately, IAG isn’t really either of those. The airline industry in general is capital intensive and it’s difficult for any company to establish a meaningful competitive advantage.

During the last couple of years, capital expenditures have been at their highest levels for a decade. And this hasn’t been helped by inflation, which has been pushing up costs.

Equally, the industry’s somewhat commoditised, with the main point of differentiation for passengers being price. This makes it difficult for any airline to gain meaningful pricing power.

Consolidation

I think IAG shares are more expensive than they look and the underlying business doesn’t look that attractive to me. Despite this, I can see a possible scenario where things look much better. 

From here, there’s a possibility the airline industry consolidates substantially. That would mean less competition and more scope to increase margins through higher prices. 

Reduced competition would benefit operators across the industry. In the case of IAG, it would help the company pay off its debt and boost profitability. 

If this happens, the stock might turn out to be a bargain at today’s prices. But that’s a big ‘if’ and it’s certainly not enough to support an investment thesis.

Value trap?

At a P/E ratio of 4, IAG shares look like a value trap to me. The amount of debt in the business means the real cost to investors is likely to be much higher than the company’s market-cap.

Overall, I think it looks a below-average business trading at a below-average price. That doesn’t sound like an obvious bargain to me.

The post At a P/E ratio of 4, are IAG shares a bargain? appeared first on The Motley Fool UK.

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Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.