Masaryk University

Faculty of Economics and Administration

Field of study: Finance

THE FUNDAMENTAL ANALYSIS OF LOW-COST AIRLINE INDUSTRY WITH REFERENCE TO

THE SELECTED COMPANIES

Master’s Thesis

Supervisor: Author:
Ing. Dagmar Linnertová, Ph.D. Tamara Harutyunyan

Brno, 2019
 MASARYK UNIVERSITY
Faculty of Economics and Administration

MASTER’S THESIS DESCRIPTION

Academic year: 2018/2019

Student: Tamara Harutyunyan

Field of Study: Finance (Eng.)

Title of the thesis/dissertation: The fundamental analysis of low-cost airline industry with reference
to the selected companies

Title of the thesis in English: The fundamental analysis of low-cost airline industry with reference
to the selected companies

Thesis objective, procedure and methods used: The goal of the diploma thesis is to analyse low-cost airline industry,
particularly Ryanair and Easy jet using fundamental approach.

The process of work:

1. Introduction
2. Characteristics of methods and procedures of fundamental analysis
3. Applying the selected methods and procedures to low-cost airline
companies
4. Summary of results and comparison
5. Conclusion and confirmation of defined goals
Methodology: analysis, comparison, deduction

Extent of graphics-related work: According to thesis supervisor’s instructions

Extent of thesis without supplements: 60 – 80 pages

Literature: REILLY, Frank K. and Keith C. BROWN. Analysis of investments &

management of portfolios. 10th ed. Australia: South-Western Cen- gage
Learning, 2012. xxvi, 1066. ISBN 9780538482486.
Equity asset valuation. Edited by Jerald E. Pinto. 2nd ed. Hoboken, N.J.:
Wiley, 2010. xx, 441 p. ISBN 9780470571439.
GRAHAM, Benjamin and David L. DODD. Security analysis: principles
and technique. 2nd ed. New York: McGraw-Hill Book Company, 1940. xiii,
851. ISBN 007141228X.
BECCALLI, E and P FRANTZ. Valuation and Securities Analysis. , University
of London, 2016.

Thesis supervisor: Ing. Dagmar Linnertová, Ph.D.

Thesis supervisor’s department: Department of Finance

Thesis assignment date: 2018/05/14

The deadline for the submission of Master’s thesis and uploading it into IS can be found in the academic year
calendar.

In Brno, date: 2019/05/10

Na m e a nd surna me of t he a ut hor :
M a s te r’s t he si s ti t le:
De pa rt me nt :
M a s te r’s t he si s supervi sor:
Tamara Harutyunyan
The fundamental analysis of low-cost airline
industry with reference to the selected companies
Finance
Ing. Dagmar Linnertová, Ph.D.

M a s te r’s t he si s da te: 2019

Annotation
This thesis examines Europe’s leading low-cost airlines. Based on the fundamental approach,
the aim is to analyse the stock price of two European low-cost carriers: Ryanair and EasyJet,
and to propose investment recommendations. The theoretical framework of fundamental
analyses is described in the first part, the second part introduces the low-cost airline industry
under the current economic and financial conditions in the area and the final part presents the
valuations and final investment recommendations.

Keywords
Fundamental analysis, low-cost airlines, equity valuation, growth
Declaration
“I certify that I have written the Master’s Thesis “The fundamental analysis of low-cost airline
industry with reference to the selected companies” by myself under the supervision of Ing.
Dagmar Linnertová, Ph.D. and I have listed all the literary and other specialist sources in
accordance with legal regulations, Masaryk University internal regulations, and the internal
procedural deeds of Masaryk University and the Faculty of Economics and Administration."

Brno,
Aut hor’s si gna t ure
Acknowledgment
I would like to take this opportunity to say my words of gratitude to the people who helped me
during the period of thesis writing.
First of all, I would like to express my gratitude to my thesis supervisor Ms. Linnertová for her
guidance, valuable recommendations and patience throughout the whole thesis writing process.
Working under your supervision was a great chance for me to gain new knowledge and grow
professionally. Thank you for your support!
I would also like to thank my parents, friends and colleagues for giving their unconditional
support, encouragement and motivation during my whole studies at Masaryk University.
 TABLE OF CONTENTS
INTRODUCTION.................................................................................................................................. 9
PART I: EQUITY STOCK VALUATION ................................................................................11
1. Company Valuation Parameters ....................................................................................................11
1.1 Value ............................................................................................................................................11
1.2 Return Concepts ...........................................................................................................................12
1.2.1 The required return on equity................................................................................................13
1.2.2 The required rate of return on capital ....................................................................................16
2. Valuation of the Company ..............................................................................................................18
2.1 Direct Valuation Methods ............................................................................................................19
2.1.1 Dividend discount model ......................................................................................................19
2.1.2 Free cash flow valuation .......................................................................................................25
2.2 Relative Valuation Methods.........................................................................................................30
2.2.1 Price to Earnings (P/E) ..........................................................................................................31
2.2.2 EV/EBITDA..........................................................................................................................33
PART II: INDUSTRY ANALYSIS ....................................................................................................34
3. Airline Industry ................................................................................................................................34
3.1 Industry Overview........................................................................................................................34
3.2 History of Low Cost Carriers: Ryanair and EasyJet ....................................................................35
4. Internal Analysis ..............................................................................................................................41
4.1 Available Seat Kilometres (ASK) ................................................................................................41
4.2 Revenue Passenger Kilometres (RPK).........................................................................................42
4.3 Load Factor ..................................................................................................................................43
4.4 Cost per Seat ................................................................................................................................44
4.5 Number of Passengers ..................................................................................................................45
4.6 Ancillary Revenue and Fleet Analyses ........................................................................................46
5. Macroeconomic Factors ..................................................................................................................48
5.1 Real Output of the Economy ........................................................................................................48
5.2 Inflation ........................................................................................................................................49
5.3 Money Supply ..............................................................................................................................50
5.4 Currency Risk ..............................................................................................................................51
5.5 The “Brexit” Referendum ............................................................................................................52
6. Competitive Environment ...............................................................................................................54
7. Partial Conclusion ............................................................................................................................57
Part III: STOCK VALUATION ........................................................................................................ 60
8. Absolute Valuation .......................................................................................................................... 60
8.1 Ryanair......................................................................................................................................... 60
8.2 EasyJet ......................................................................................................................................... 70
9. Relative Valuation ........................................................................................................................... 75
10. Investment Recommendations ...................................................................................................... 79
CONCLUSION .................................................................................................................................... 81
BIBLIOGRAPHY ................................................................................................................................ 83
LIST OF ABBREVIATIONS ............................................................................................................. 86
LIST OF FIGURES ............................................................................................................................. 87
LIST OF TABLES ............................................................................................................................... 88
APPENDIX........................................................................................................................................... 89
 INTRODUCTION

The fact that low cost airlines have revolutionized the way people fly is not a secret for
anyone. The ever-increasing role of low-cost carriers forces one to pay attention to this
phenomenon and actively study it. In 2018, according to IATA (International Air Transport
Association), low-cost airlines provided 36.3% of all regular passenger traffic in the world.
The giants of the industry are Ryanair and EasyJet, which now carry more passengers than
British Airways. Thanks to these two carriers, millions have now chance to experience more
of the world than they used to. People prefer to sacrifice comfort for cheap flights which
creates room for higher competition among low-cost carriers. They are now fighting for
passengers all over Europe.

With Ryanair dominating the industry and EasyJet following after, these two low cost carriers
are profiting in a macroeconomic environment, while their competitors are failing to survive.
And therefore, for an investor, who is looking for a steadily growing business to invest in,
these two airlines can be a good option. In a rapidly changing macroeconomic environment
and under uncertainties connected to Great Britain’s intention to leave EU, it is essential to
evaluate all the challenges and opportunities the business can face before doing any
investment. It is of interest to know whether the companies are fairly priced and whether the
growing trend from the previous years still holds true. In this regard, the research topic
presents considerable academic and practical interest.

The main goal of the diploma thesis is to analyse low-cost airline industry, particularly
Ryanair and EasyJet using the fundamental approach. The question has been raised whether
the two companies are fairly valued and worth to invest in. Thus the internal values of the
selected carriers’ stocks are determined through appropriate methods of fundamental analysis
and investment recommendation are stated. The organizational structure of the thesis is as
follows:

Part 1 Presents the characteristics of methods and procedures of fundamental analysis and
describes the models most appropriate for the stock value of the chosen companies. The two

9
most widely used approaches of fundamental analysis: absolute and relative valuation
methods are introduced with emphasis on discounted cash flow models and the analysis of
multiples.

Part 2 Communicates a detailed picture of the industry and its competitors, as well as the
company’s current situation and further possible developments. It starts with the history and
continues with the current financial health of the companies, looking at their financial
statements. Furthermore it expands on the possible fluctuations of the stock prices depending
on the economic environment are introduced. The next chapter stands for competitive
analyses of the industry. The second part is summarized with a SWOT analysis and represents
a partial conclusion of the internal and external factors that can have an impact on the
businesses.

Part 3 Introduces the stock valuation of Ryanair and EasyJet and gives final investment
recommendations. Methods of fundamental analysis described in the first part of the thesis
are implemented to originate the intrinsic value of the stocks for the final comparison with
the current market value. The 3rd part also includes sensitivity analysis for a wider
understanding of the possible outcome fluctuations. This part is summarized with the author’s
final investment recommendations.

Main sources of information

 Bloomberg database.
 Annual reports of individual air carriers.
 Electronic databases and aviation transport websites.
 Official documents of leading international organizations in the field of civil aviation.
 Articles on the subject of low-cost air travel, literary sources.

The theoretical framework described in this thesis is mainly based on relevant scientific
literature while the analysis and valuations are done using financial statements of the
companies as the main sources.

10
PART I: EQUITY STOCK VALUATION
“Valuation is an art, not a science”
SETH A. KLARMAN, 2008

Everything has a value, be it a stock, time or a person. And this value is not always precisely
determined. Thus people have to evaluate everything they want to invest in. Being risk
averse, majority of people would invest in something they find more valuable than the others.
However, the valuation process is not that straightforward as it may seem from the first sight.
To come up with the real value of any asset one must do comprehensive analyses of past,
current and future developments of it. In finance, the fundamental approach is believed to be
the right path towards asset valuation for long-term investments.

1. Company Valuation Parameters

To achieve the goal of the thesis fundamental approach of analysing a company’s stock value
will be used. For that, one of the initial tasks is defining the basic valuation concepts. This
chapter focuses on defining the concept of value, company valuation tools, describing the
reasons for the company valuation.

1.1 Value
Before coming to equity valuation tools and going through all the models used in the work it
is worth to define what is meant by “value” and what concepts of value are going to be used.
The starting point is the intrinsic value.

Intrinsic value is the actual value of the security, as opposed to its market price or book value,
and is assumed to reflect all the investment characteristics of it. (Pinto, Henry, Robinson,
Stowe 2010).

Efficient market theory suggests that the best estimate for an asset’s intrinsic value is its
market price. The rational efficient markets theory formulated by Grossman and Stieglitz
(1980) (cited in Pinto et al., 2010) recognizes that investors will spend additional money on
gathering information about the intrinsic price of the security only if they expect to be
rewarded by higher returns. In general equity valuation supposes mispricing of market traded

11
securities. But, even as a result of the most careful valuation, the final numbers will not be
without uncertainty as there are hundreds of assumption about a company that will make
biases. Thus every analyst should have a reasonable margin for errors in valuation that was
done.

Other concepts of value are also important. The going-concern value is the value of the
company which works under the assumption that the company will continue operating for
the foreseeable future. In contrast liquidation value is the value of the company if it were
dissolved. (Pinto et al., 2010).

The focus of this diploma thesis will be the intrinsic value, estimated under a going –concern
assumption using the bottom-up approach.

1.2 Return Concepts

Company valuation means using various models to evaluate the stock of that company. These
models have some inputs which are essential in the process so they need to be discussed
separately. One of those important inputs is the discount rate.

Investments are evaluated in terms of the return they can earn compared to a level considered
as fair given all the information about the risks of investment. While evaluating a company’s
stock or any other investment it is important to specify which rate the future cash flows are
going to be discounted with.

Required return
A required rate of return is the minimum level of expected return that an investor requires in
order to invest in the asset over a specified time period given the asset‘s riskiness. In other
words, it is the opportunity cost for investing in that asset, thus it can be called a fair
compensation for the asset’s risk. Which means if the investor’s expected rate of return is
higher than the required rate of return the asset is undervalued, in the opposite case the asset
is overvalued. The difference between these two values is called the asset’s expected alpha.
One thing analysts usually examine is the realized alpha which is the difference between the
actual holding period return and the existing required return. The notation for the required

12
rate of return will be r. Cost of equity and cost of debt are respectively, the required rate of
return on common stock and debt. (Pinto et al., 2015.)

1.2.1 The required return on equity

For estimating the expected return on equity capital asset pricing model (CAPM) is used.
According to that theory, the expected return of a security is equal to the sum of a risk-free
asset’s rate of return and a risk premium. The two key assumptions of the model are:

 All the investors are risk-averse and they tend to do diversification of portfolio to
reduce the risk.
 Investors make decisions on investing based on risk and return. CAPM also assumes
that investors are rational and they discard from unsystematic risk. (Madura, 2010)

The formula of the model can be expressed as:

𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 (𝐸(𝑅𝑀 − 𝑅𝑓 )) (2)

Where,

𝐸(𝑅𝑖 )=expected return of investment

𝑅𝑓 =risk free rate

𝛽𝑖 =beta of the investment

𝐸(𝑅𝑀 − 𝑅𝑓 )=market risk premium

The equity risk premium

The equity risk premium is the extra amount of return that investors require for preferring
equities over risk-free assets. So it represents the difference between the required return on
equities and risk-free rate. Risk-free return is the return of an investment which has a
guaranteed return without a risk. (Damodaran, 2013).
Usually, interest rate on three-month U.S. Treasury bills (T-bill) is used as a short-term risk-
free rate.

13
There are two basic approaches on how to estimate the equity risk premium. One is based on
historical data the other one on current data.

Equity risk premium based on historical data

To calculate the equity risk premium based on historical data a sample period is being chosen,
and then the mean value of differences between equity market index return and government
debt return over that period is calculated. An important assumption for this approximation is
stationary returns. There are four factors which need to be selected for the equity risk
premium estimation based on historical data: The risk-free return, the time period, type of
mean, the equity index to represent equity market returns. (Pinto et al., 2010)

 As a proxy for the risk-free return a long-term government bond yield to maturity or
a short-term government debt instrument’s rate can be selected (Ex. 30-day T-bill
rate).The longer the time period taken the more accurate is the estimation, however,
it may negatively affect the stationarity assumption.
 As a method for mean calculations both geometrical and arithmetical methods can be
used. The arithmetic mean is favorable when single period models are used, for
example, CAPM or multifactor models.
 And the last factor, the index should be chosen right so as they represent averaged
returns earned by investors precisely, are market value-weighted and wide-ranging.

Historical risk premium estimates are not free of biases. One of them is so-called survivorship
bias. It occurs when poorly performed companies are not included in the stock index, but
only winners remain. Thus the analysts should choose equity return series that are free from
such bias or the historical risk premium estimate should be adjusted downward. (Pinto et al.,
2010)

Equity risk premium based on current information

In this approach, equity risk premium is estimated based on current information and
expectations. In other words, estimates like this are called forward-looking. As an example
of this kind of estimation can be the Gordon growth model,

14
 Expected dividends next period
V = Required return on equity−Expected growth rate (1)

Where three out of four variables (the current value of the stock, the expected dividends for
the next period, and the expected growth rate) can be obtained externally and thus r can be
found easily. (Damodaran, 2013)

The Beta parameter

The beta parameter is an important indicator in the required rate of return’s calculation. It
measures assets’ systematic risk, it’s volatility in comparison to the market portfolio. As a
representative of the market portfolio a broad value-weighted equity market index is chosen.
If the stock was more volatile than the market, its beta coefficient will be greater than one, if
the opposite happens than the beta coefficient will be less than one. Beta can also be
interpreted as a risk measure. The higher it is the higher is volatility, so the expected return
should also be higher to compensate for the risk. Thus beta parameter is a useful tool for
expected return’s estimation. (Focardi and Fabozzi, 2004).

One of the methods to estimate the beta coefficient is an ordinary least squares regression.
The result of the regression is called unadjusted or “raw” beta. The estimated beta is much
influenced by two factors. First one is the choice of the index as a market portfolio
representative. There are traditional choices for some markets, for example, S&P 500 for the
US. The second factor is data length and the frequency of observations. Usually, 5 years of
monthly data with 60 observations are used. (Damodaran, 2013).

To predict the future beta more precisely Blume (1971) (cited in Pinto et al., 2010) offered
an adjustment for it.

𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑏𝑒𝑡𝑎 = 2/3(𝑢𝑛𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑏𝑒𝑡𝑎) + 1/3(1.0) (3)

Another way to estimate beta is just by using a formula for it. The expression of the formula
is the covariance between the return of the stock and the market return divided by the variance
of the market. (Focardi and Fabozzi, 2004)

A key determinant in beta estimation is leverage- the company’s debt to equity ratio. The
following expression shows how the capital structure affects the beta factor:

15
 𝐷
𝛽𝐿 = 𝛽𝑈 ∗ [1 + (1 − 𝑡) 𝐸 ] (4)

Where,

𝛽𝐿 − 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎

𝛽𝑈 − 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎

𝑡 − 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

𝐷
− 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜
𝐸

Levered beta presumes that firms have debt and equity in their capital structure, while
unlevered beta compares the market with companies assuming they do not have a debt. The
more is the debt in a company’s capital structure the more sensitive is the company to its
stock price changes. So unlevered beta is there to have just the sensitivity of a firm’s equity
to the market factored. When a stock is not traded publicly, its beta can be measured taking
a peer company’s beta as a base. To avoid problems with different capital structures
unlevered beta should be used (Pinto et al., 2010).

1.2.2 The required rate of return on capital

Since it was shown how to estimate the required rate on equity it is worth now to talk about
the cost of capital calculations. Company’s cost of capital is the required rate of return of its
all capital suppliers. To estimate this variable weighted average cost of capital (WACC) is
mostly used. In other words, WACC is the weighted average of required returns for all capital
components (Brigham, Houston and Brigham, 2010).

Under the assumption that capital suppliers of the firm are creditors and common
shareholders the formula for WACC will be as following: (Pinto et al., 2010)

𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝐷+𝐸 ∗ 𝑟𝐷 (1 − 𝑡) + 𝐷+𝐸 ∗ 𝑟𝐸 (5)

Where,

16
D = market value of the company ′ s debt,

𝐸 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 ′ 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦

𝑟𝐷 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡

𝑟𝐸 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

The required rate of return for the company’s debt should be calculated on after-tax basis. As
the interest component of debt is deductible from taxable income the income tax paid by a
company will be lower, in contrast, the distributions to equity are not tax deductible, so the
cost of equity before and after tax is the same. As the cost of debt, the expected yield to
maturity (YTM) is mainly used (Brigham, Houston and Brigham, 2010).
With the changing of a company’s capital structure WACC may also change during the time.
Sometimes target weights replace the current weights while calculating WACC to represent
the analysts’ and investors’ expectations about the future weights which can be different from
what they have in present (Brigham, Houston and Brigham, 2010).
WACC is a very useful indicator while evaluating any company, as it shows the cost of
capital across all sources, thus it can be used for calculating other company efficiency
indicators. One example of it can be EVA (Economic Value Added). EVA as a company
valuation indicator was firstly used by Stewart & Co in 1990s. This concept shows the value
added by the company and is calculated by deduction of full costs of capital from the income.
It is the comparison of the net operating profit generated by the company (adjusted by taxes)
and the firms total cost of capital. (Reilly, Brown and Leeds, 2018). Thus, the positive value
of EVA states that during a specific year a firm’s NOPAT (net operating profit after tax) was
higher than cost of capital and that the firm has created a value. The opposite is also true, if
NOPAT does not exceed cost of capital than the company was not able to cover the costs by
the net operating profit, so the value wasn’t created in the company.

17
2. Valuation of the Company
Company valuation methods are classified into four categories based on two aspects. The
first aspect differentiates direct and indirect valuation methods, while the second aspect
distinguishes cash flow models and models that rely on other variables such as sales,
earnings, book value etc. As one can guess from their names direct valuation models suggest
a direct estimate of the company’s fundamental value. After obtaining that value, analysts
usually compare it with market value to have a view if the company is fairly valued or there
is over or undervaluation. Alternatives are relative valuation methods. Here analysts do not
have an estimate for the fundamental value of a company, but a relative value which has to
be compared with peer companies. And the result they get is whether the company is fairly
priced relative to some benchmark or peer groups. Table1 provides an overview of the
mainstream valuation methods (Petitt and Ferris, 2013).

Table 1: Overview of Valuation Methods

Valuation methods that rely in Valuation methods that rely on a
cash flows financial variable other than cash
flows
Direct (or Absolute) Valuation
Methods Discounted cash flow models: Economic income models:
FCFF model
Economic value analysis
FCFE model

Adjusted present value model

Option-pricing models:
Real option analysis

Price multiples: Price multiples*:

Relative (or Indirect) Valuation
Price-to-cash-flow ratio Price-to-earnings ratios (P/E ratio,
Methods
P/EBIT ratio, and P/EBITDA ratio),

Price-to-sales ratio

Price-to-book ratio

Enterprise value multiples:

EV/EBITDA multiple

EV/Sales multiple
Source: S., B., 2013. Valuation for Mergers and Acquisitions (2nd Edition). Ft Press.

18
2.1 Direct Valuation Methods
Among the direct valuation models, the most famous ones are discounted cash flow models
(DCF). The base of this approach is the present value rule, which says that the value of any
asset is the present value of expected future cash flows generated by that asset (Pinto et al.,
2010).

In terms of formulas:

𝐶𝐹
𝑉0 = ∑𝑛𝑡=1 (1+𝑟)
𝑡
𝑡
(6)

Where,

𝑉0 = 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡 ′ 𝑠 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 0

𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡

𝐶𝐹𝑡 = 𝑡ℎ𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡

𝑟 = 𝑡ℎ𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

For every asset the cash flow is different. It is dividend for stocks, coupon and face value for
bonds and for real projects cash flow is after-tax payments. The discount rate reflects the
riskiness of the asset, so it is higher for riskier assets. Further, in this thesis, there will be an
introduction of different DCF models: the dividend discount model and the free cash flow
model.

2.1.1 Dividend discount model

As the name suggests in this model the role of cash flows play dividends. This model is used
when the investor who buys and holds a stock is receiving cash flows in terms of dividends
for them. The stock is priced by adding all future dividends discounted by risk-adjusted
required rate of return (Pinto et al., 2010).

Not all stocks pay dividends regularly. For instance, non-profitable companies may lack
resources to pay dividends. But the opposite is also true, some highly profitable companies

19
do not pay dividends because they are willing to reinvest the earnings. In general, the more
mature company is the more it is unwilling to reduce dividends (Brav et al., 2004).

For the companies who are not paying dividends regularly, DDM is not applicable. Further
in this work, other models for this kind of companies will be introduced.

For multiple holding periods the expression of this model will be the following:

𝐷 𝑃
𝑉0 = ∑𝑛𝑡=1 (1+𝑟)
𝑡
𝑡
𝑛
+ (1+𝑟)𝑛
(7)

Where,

𝑉0 = 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑎𝑡 𝑡𝑖𝑚𝑒 0

𝐷𝑡 = 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 𝑡

𝑃𝑛 = 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑛

The price valuation with this formula requires forecasting the upcoming dividends and the
selling price of the stock.

This formula is right when the owner plans to sell the stock in the near future, but when the
time horizon of holding the stock is infinite the following formula comes to replace the
previous one:

𝑡 𝐷
𝑉0 = ∑𝑡=1 (1+𝑟)𝑡
(8)

Using DDM is not that easy as it may seem. The biggest challenge here is in forecasting an
infinite number of dividends. There are two ways how to do it and each of them suggests
different variations of the forecasting process (Pinto et al., 2010).

1. The first approach to forecasting is defining a growth pattern for the cash flows.
Patterns that are used for this purpose are:
 Constant growth models (Gordon Growth model).
 Two stages of growth (the H-model and two-stage growth model).
 Three stages of growth (the three-stage growth model).

20
 2. The second approach is forecasting dividends up to some point based on the
company’s earnings. The time horizon depends on the predictability of the required
indicators. And then forecast:
 Either the remaining dividends coming after that point (using the first approach).
 Or the terminal share price using indicators such as forecasted book value or
earnings per share.

The Gordon growth model

As mentioned above the simplest assumption on which one can build a dividend growth
model is “constant rate”. This pattern of growth was suggested by Gordon and Shapiro (1956)
and Gordon (1962), they believed dividends grow indefinitely at a constant rate.
Mathematically this can be shown with the following formula:

𝐷𝑡 = 𝐷𝑡−1 (1 + 𝑔) (9)

Where,
𝑔 = 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝐷𝑡 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡

Based on that a new formula for DDM can be derived:

𝐷0 (1+𝑔) 𝐷0 (1+𝑔)2 𝐷0 (1+𝑔)3 𝐷0 (1+𝑔)𝑛

𝑉0 = (1+𝑟)
+ (1+𝑟)2
+ (1+𝑟)3
+⋯ (1+𝑟)𝑛
+ ⋯, (10)

Or in more compact way:

𝐷0 (1+𝑔)
𝑉0 = (11)
𝑟−𝑔

Which is valid only if r is more than g.

The Gordon growth model is useful when the goal is to evaluate a stock of business with
earnings expected to grow at a stable rate, which is comparable or lower than the nominal
growth rate of the economy (Pinto et al., 2010).

21
Multistage dividend discount models
The Gordon growth model can be a base for building other models but it is not realistic for
the majority of companies, because the probability that there will be a stable dividend growth
rate indefinitely is very low. In general, practitioners suggest three growth stages that
company could have (Pinto et al., 2010).

 Growth phase. In this phase companies, usually, benefit from flourishing markets,
have high profit margins and growth rate in earnings per share. Here companies invest
in growing operations that is why they usually have a negative free cash flow to equity
and low dividend pay-out ratio.
 Transition phase. This is the phase of transition to maturity, in which growth in
earnings per share slows down. There is oftentimes positive free cash flow and
increasing dividend pay-out ratio.
 Mature phase. This is the phase when the Gordon growth model can be used for
company valuation because in maturity usually dividend pay-out ratio and return on
equity are stabilized and are stable over long periods of time.

Regarding the above-mentioned information, it will be useful to define multistage models for
evaluating companies which are in their growth phase.

Two-Stage dividend discount model

In this model, a high growth rate is assumed for the first period and lower and sustainable
growth rate thereafter. Mathematically the expression will be:

𝐷0 (1+𝑔𝑆 )𝑡 𝐷0 (1+𝑔𝑆 )𝑛 (1+𝑔𝐿 )

𝑉0 = ∑𝑛𝑡=1 (1+𝑟)𝑡
+ (1+𝑟)𝑛 (𝑟−𝑔𝐿 )
(12)

Where,

𝑔𝑆 = 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑠ℎ𝑜𝑟𝑡 − 𝑡𝑒𝑟𝑚 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒

𝑔𝐿 = 𝑛𝑜𝑟𝑚𝑎𝑙 𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒

The two-stage DDM model is a very useful tool because it is very common when companies
have a supernormal growth for some period and then it drops to a more steady level. Reason

22
for it can be for instance possession of a patent or first-mover advantage (Corporate Finance
Institute, 2019).

The H-model
In Two-stage discount model, the difference between the first growth rate and the second one
is usually significant. And the transition between the initial supernormal growth period and
the final normal growth period is curt. The H-model is again a two-stage model but in contrast
with the basic two-stage model, the growth here becomes to fall linearly until it reaches a
normal rate at the end (Pinto et al., 2010).

𝐷0 (1+𝑔𝐿 )+𝐷0 𝐻(𝑔𝑆 −𝑔𝐿 )

𝑉0 = (13)
𝑟−𝑔𝐿

Where,

𝐻 = ℎ𝑎𝑙𝑓 − 𝑙𝑖𝑓𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠 𝑜𝑓 𝑡ℎ𝑒 ℎ𝑖𝑔ℎ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑝𝑒𝑟𝑖𝑜𝑑

Three-stage dividend discount model

Two basic three-stage discount models are distinguished. In the first one, the growth rate in
the middle phase is constant, while in the second one the growth rate declines linearly in
stage two and becomes constant is stage three. So basically the second and third stages
represent the H-model (Pinto et al., 2010).

Sustainable growth rate

In the models described above the sustainable growth rate was mentioned several times. It is
useful to study this concept to use it in the calculation of the stable growth rate in the Gordon
growth model or of the mature growth rate in a multistage DDM. Sustainable growth rate
calculation can be expressed in the following way: (McMillan et al., 2011)
𝑔 = 𝑏 ∗ 𝑅𝑂𝐸 (14)
Where,
𝑔 = 𝑑𝑖𝑣𝑖𝑑𝑛𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
𝑏 = 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒(1 − 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜)
𝑅𝑂𝐸 = 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦

23
This formula comes from the assumption that the return on equity can be a good
approximation for the rate of return (ROE=r). This assumption makes sense, because it is
based on another assumption which states that in their mature phase companies can only earn
investors’ opportunity cost of capital. Based on the last equation the higher the return on
equity the higher the dividend growth rate, holding the else constant. The equation also
implies the lower the earnings retention ratio the lower the dividends growth rate, all other
factors being constant. The weakness of this concept is the expression all else constant. It
seldom happens that returns on reinvested earnings are constant or that companies do not
change their dividend paying policy for a long time especially ones with changing future
growth prospects. Thus the growth rates predicted by the above mentioned equation (14) may
be different from the actual one. However, the equation is a useful approximation for the
average dividend growth rate over a long time horizon (Pinto et al., 2010).

The term ROE was used in the description of a company’s sustainable growth. Now the
following few sentences will expand the model and describe it. ROE shows how much net
income is generated from an investment in stockholders’ equity.

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐸 = (15)
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦

The last expression can be expanded by using the DuPont formula, which states that:

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

𝑅𝑂𝐸 = ∗ ∗ (16)
𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦

This formula divides return on equity into three components: profit margin, total asset
turnover and equity multiplier (McMillan et al., 2011).

If we combine the (14) and (16) formulas another expression for dividend growth rate will
be available:

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒−𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

𝑔= ∗ ∗ ∗ (17)
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦

These formulas are based on the assumption that ROE is calculated using beginning-of –
period shareholders’ equity and that until the end of the period there are no available retained
earnings for reinvestment. This model is called PRAT (profit margin, retention rate, asset

24
turnover and financial leverage) (Higgins, 2007). It is worth mentioning that two factors in
the PRAT model represent the financial policy of the company (retention rate and financial
leverage), meaning that companies can directly affect these factors, while the other two
factors are driven from the performance. Which means that they are not under the control of
the company and can affect the dividend growth rate. Thus their prediction will have more
biases and less accuracy (Pinto et al., 2010).

2.1.2 Free cash flow valuation

Within the framework of discounted cash flow models, another concept for intrinsic value
valuation can be FCFF (free cash flow to the firm) and FCFE (free cash flow to equity).
Unlike the dividends which are the cash flows paid to the stockholders, free cash flows are
the cash available for giving out to shareholders. Free cash flows are used whenever the
company does not pay dividends. Further, in this thesis, the background required for using
FCFF and FCFE approaches for the company’s equity valuation will be described.

The remaining cash flow which is available to capital suppliers of the company after paying
the operating expenses and doing all the investments in working and fixed capital is called
free cash flow to the firm. In contrast, the free cash flow to equity is the remaining free cash
available only to common equity holders. There are other cash flow concepts in accounting
data of the company such as cash flows from operation (CFO), EBIT or EBITDA but these
values cannot be used in DCF model for equity or firm valuation. There are various reasons
why. One of them is that EBIT/EBITDA are before-tax measures but the cash flows must be
after tax, the other one is the reinvestment of cash flows in capital assets that these measures
do not account for, the differing capital structures are not considered in these measures as
well. Coming to the characteristics of FCFF. As it is a cash flow which goes to all suppliers
of capital to the firm the weighted average cost of capital (WACC) will be taken as a discount
rate as it gives the value of the firms’ whole capital. The value of equity can be found either
directly by discounting FCFE at the required rate of return from equity or indirectly by
subtracting value of the debt from the value of the firm. FCFE approach will be more suitable
for the companies whose capital structure is relatively stable. In contrast, FCFF is better to

25
choose when the analyst works with a levered company with negative FCFE or a levered
company with a changing capital structure (Pinto et al., 2010).

In the following, the valuation models with FCFF and FCFE will be described:

Present value of FCFF

The value of the firm is estimated as the present value of free cash flows to the firm. As it
was mentioned above for FCFF model the discount rate is the weighted average cost of
capital:
𝐹𝐶𝐹𝐹
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = ∑∞ 𝑡
𝑡=1 (1+𝑊𝐴𝐶𝐶)𝑡 (18)

It was shown how to value the firm and equity by using FCFF. But unlike the dividends given
by the company FCFF and FCFE are not that straightforward to find in financial statements.
Now the context for the estimation of these two values will be described.

As the definition of FCFF states, there are the cash flows left to pay to all companies’ capital
providers, including shareholders and creditors, after covering capital expenditures and
working capital needs. Thus it includes the cash created by all assets of the company,
independently of how those assets are financed. There are 4 financial statement items starting
from which FCFF can be derived (Net income, EBIT, EBITDA, and cash flow from
operations (CFO)). But these indicators need to be adjusted to represent FCFF (Robinson,
2009).

Calculating FCFF from net income:

𝐹𝐶𝐹𝐹 = 𝑁𝐼 + 𝑁𝐶𝐶 + (𝐼𝑛𝑡 ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)) − 𝐹𝐶𝐼𝑛𝑣 − 𝑊𝐶𝐼𝑛𝑣 (19)

Where,
𝑁𝐼 = 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑁𝐶𝐶 = 𝑛𝑜𝑛𝑐𝑎𝑠ℎ 𝑐ℎ𝑎𝑟𝑔𝑒𝑠
𝐼𝑛𝑡 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝐹𝐶𝐼𝑛𝑣 = 𝑓𝑖𝑥𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠)
𝑊𝐶𝐼𝑛𝑣 = 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

26
Net income should be adjusted by noncash charges as they are expenses which reduce net
income but does not generate any cash outflow. Most often these noncash charges are
Depreciation for tangible and amortization for non-tangible assets.

Interest expenses are cash flows that are available to the firm before making payments to
capital suppliers, however, they are expensed on the income statement. Thus they need to be
added back adjusted by tax payments.

Fixed capital investments, which are the difference between capital expenditures and
proceeds from sales of long-term assets, are a form of cash outflow not represented in net
income that is why they also need to be added.

Net working capital is the current operating assets minus current operating liabilities. There
will be a plus sign if there is a reduction in working capital because it represents a cash inflow.

Calculating FCFF from EBIT

𝐹𝐶𝐹𝐹 = [𝐸𝐵𝐼𝑇 ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)] + 𝐷𝑒𝑝 − 𝐹𝐶𝐼𝑛𝑣 − 𝑊𝐶𝐼𝑛𝑣 (20)

Where,
𝐸𝐵𝐼𝑇 = 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑒𝑠
𝐷𝑒𝑝 = 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

EBIT is the earnings before interest and taxes. Depreciation is subtracted out from it so it
needs to be added back. Here there is no need to subtract interest because as it was mentioned
EBIT is a measure before interest and taxes. The adjustment for taxes is done to compute
after-tax EBIT. The other two components were already described above.

Calculating FCFF from EBITDA

Another way to get FCFF is to start form earnings before interest, taxes, depreciation and
amortization (EBITDA)

𝐹𝐶𝐹𝐹 = [𝐸𝐵𝐼𝑇𝐷𝐴 ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)] + (𝐷𝑒𝑝 ∗ 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) − 𝐹𝐶𝐼𝑛𝑣 − 𝑊𝐶𝐼𝑛𝑣 (21)

Where,

𝐸𝐵𝐼𝑇𝐷𝐴 = 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑡𝑎𝑥𝑒𝑠, 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛, 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛

27
The only difference with the previous one is the depreciation tax shield. It needs to be added
because the free cash flow available is increased by the taxes saved.

Calculating FCFF from CFO

The last way of expressing FCFF is by using cash flows from operations (CFO) from the
cash flow statement.

𝐹𝐶𝐹𝐹 = 𝐶𝐹𝑂 + [𝐼𝑛𝑡 ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)] − 𝐹𝐶𝐼𝑛𝑣 (22)

Cash flows from operations already include net income, noncash charges and investments in
working capital. So to come to FCFF the after-tax interest should be added back, as it is
reflected in the income statement to get the net income. And the fixed capital investment
should be subtracted out (Robinson, 2009).

The present value of FCFE

The value of equity is estimated as the present value of free cash flows to equity (FCFE). The
discount rate for this mode is required rate of return on equity

𝐹𝐶𝐹𝐸
𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = ∑∞
𝑡=1 (1+𝑟)𝑡 (23)

Another way to find the value of equity is just by subtracting the value of debt from the value
of the firm.

𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 = 𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (24)

Calculating FCFE

Calculating FCFE from FCFF

There are several ways for FCFE calculation. One is deriving it from FCFF: (Robinson, 2009)

𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹𝐹 − [𝐼𝑛𝑡 ∗ (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)] + 𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 (25)

Where,

𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 = 𝑙𝑜𝑛𝑔 𝑎𝑛𝑑 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑛𝑒𝑤 𝑑𝑒𝑏𝑡 𝑖𝑠𝑠𝑢𝑒𝑠 −

𝑙𝑜𝑛𝑔 𝑎𝑛𝑑 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

28
As FCFF doesn’t include cash flows to bondholders it should be adjusted by those two
amounts, which are after-tax interest expense and new borrowings (long or short term).

Calculating FCFE from net income

𝐹𝐶𝐹𝐸 = 𝑁𝐼 + 𝑁𝐶𝐶 − 𝐹𝐶𝐼𝑛𝑣 − 𝑊𝐶𝐼𝑛𝑣 + 𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 (26)

The differences with this expression and the one for FCFF are just that after-tax interest
expenses (not added back) and net borrowings (added back).

Calculating FCFE from CFO

𝐹𝐶𝐹𝐸 = 𝐶𝐹𝑂 − 𝐹𝐶𝐼𝑛𝑣 + 𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 (27)

The logic here is the same fixed capital investments should be subtracted from CFO and net
borrowings should be added back since they increase cash available to shareholders
(Robinson, 2009).

When the capital structure of the company is relatively stable FCFE can be used more
smoothly, however in case of negative FCFE and a great deal of debt in capital structure
FCFF is more suitable.

Forecasting FCFF and FCFE

One of the two approaches of forecasting FCFF and FCFE is based on historical data and on
assumption that the growth rate will be stable. In other words, it works under the assumption
that the historical growth rate will also apply to the future.

The second approach suggests forecasting all the components of these indicators for each
year separately. This method is more complicated but more realistic. One of the features of
it is that future capital expenditures, depreciation expenses and changes in working capital
are connected with forecasts in sales and thus with the size of the company. In addition,
during FCFE forecasting fixed debt to asset ratio is assumed (Pinto et al., 2010).

To express the intrinsic value of a firm and equity growing at a constant growth rate can be
expressed using a formula:

29
 𝐹𝐶𝐹𝐹1 𝐹𝐶𝐹𝐸1
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = (28.1) 𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = (28.2)
𝑊𝐴𝐶𝐶−𝑔 𝑟−𝑔

A general expression for the two - stage FCFF and FCFE valuation models are:

𝐹𝐶𝐹𝐹𝑡 𝐹𝐶𝐹𝐹𝑛+1 1
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = ∑𝑛𝑡=1 + ∗ (29.1)
(1+𝑊𝐴𝐶𝐶)𝑡 (𝑊𝐴𝐶𝐶−𝑔) (1+𝑊𝐴𝐶𝐶)𝑛

𝐹𝐶𝐹𝐸𝑡 𝐹𝐶𝐹𝐸𝑛+1 1
𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = ∑𝑛𝑡=1 + ∗ (29.2)
(1+𝑟)𝑡 𝑟−𝑔 (1+𝑟)𝑛

2.2 Relative Valuation Methods

While the focus in academic discussions remains on discounted cash flow valuation, it is
useful to value assets on a relative basis as well. In this method asset’s value is compared to
the market values for similar or comparable assets. Sometimes relative valuation is more
preferable to use because it reflects market expectations and moods. Furthermore, with this
method, less information is required and it is straightforward to find if the given share price
is undervalued or overvalued compared with its competitors. It is easier to prove the
worthiness of buying a stock when it is compared with other stock because one can always
find something more overvalued. As long as analysts can pick the multiple and the
comparable they can come up with any result of the valuation they want. Another secret
which makes relative valuation easier is that assumptions made here are not that obvious as
in intrinsic valuation method. And last, if an analyst will be mistaken with his/her intrinsic
valuation it is only his/her fault and he/she is the only one who is responsible for it, in contrast
with relative valuation, where everything is done in comparison. Taking all above-mentioned
factors into consideration, we have decided to use both methods in our thesis, so that relative
valuation can help to find weak spots in absolute valuation and fix them. To make
comparisons across companies multiples are used, which are standardized estimates of price.
Every multiple has a numerator and denominator. In the numerator there is always a measure
of the market value, it can be the market value of equity, the market value of equity plus the
value of debt, which is the market value of the firm, the market value of equity plus the value
of debt minus cash that’s the enterprise value. In the denominator, there can be four possible

30
measures: revenues, earnings, EBITDA, the book value of equity or book value of the entire
firm. There can be even some sector-specific measure like the market value per employee,
market value per output unit. One thing, which is in common with all these measures is that
they are scaling company value to a measure of the company’s performance (Damodaran,
2006).
To come up with the right multiplier to use there are several rules analysts have to follow.
The first one is the consistency of the multiples, meaning if the numerator is, for example, an
equity value the denominator should be an equity value as well, or they both should be a firm
or enterprise value. The most widely used two multiples are consistent (P/E, EV/EBITDA).
In contrast to them price to EBITDA ratio is not consistent as the numerator is an equity
value, however EBITDA is operating cash flow. It may seem that this will not be a problem
if this multiple is used for all the companies being evaluated, however, if one of the
companies has borrowed money and enlarged its debt it will drop the market value of equity
but not the EBITDA, thus this will incorrectly make cheaper a company which has borrowed
a lot of money. The second rule one must follow when using relative valuation is to make
sure the multiples are estimated in the same way for all the companies. While collecting the
data analysts can look at historical data, current data or forward-looking ones. It is mostly the
forward-looking data which is analysed for the relative valuation of peer companies
Then it is essential to understand what is going to be compared with what, meaning which
companies can be called comparable. When determining a peer group one must look at
qualitative and quantitative measures. Examples of qualitative measures are the similarity of
products, the geography of the company’s operations, consumers and suppliers. Quantitative
measures include size, performance and risks of the companies (Damodaran, 2006).
The most famous price multiple is P/E price to earnings ratio. Firstly in this section this
multiplier will be introduced.

2.2.1 Price to Earnings (P/E)

The price to earnings ratio shows the relation between a company’s stock price (P) and
earnings per share (EPS). In simple terms, this ratio shows the price an investor must pay per
unit of earnings. P/E ratio can be expressed by the following formula:

31
 𝑃 𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
= (30)
𝐸 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Nothing can be concluded by just looking at the ratio and its value. This value is meaningful
only in comparison with the historical P/E or with the P/E of a peer company from the same
industry.

The numerator of the P/E ratio is very straightforward to get for publicly traded companies,
in contrast, the denominator should be selected carefully. Based on the time horizon over
which earnings are calculated P/E definitions may vary.

 Trailing P/E: The stock’s current trailing P/E is the ratio between its current market
price and the last four quarters EPS. This estimate of P/E is more reliable because it
is based on already reported information. However, a disadvantage of this method is
that it is not always right to build expectations about future behaviour based on past
performance.
 Forward P/E: The stock’s forward P/E is its current market price divided by next
year’s expected EPS. This method is useful for comparison between current and
future earnings. A disadvantage of this method is possible earnings underestimation
for beating the estimated ratio.

Instead of choosing between two definitions of P/E it is better to use both and try to determine
why sometimes they have different values. For instance, for fast-growing companies the
forward P/E will be higher than the trailing P/E and for the companies who sell a significant
part of its business, the trailing P/E will be more than the forward P/E.

Against the problem of cyclicality normalized EPS is used. A normalized EPS is the
calculation of earnings that the company is currently able to reach under midcyclical
conditions (Damodaran, 2006).

32
2.2.2 EV/EBITDA
Another relative multiple that is used widely is enterprise value to EBITDA. EV/EBITDA is
a valuation method for the whole company not just for its common stock. The latter can be
induced from the fact that enterprise value includes the market value of debt, common equity
and preferred equity. In addition, EBITDA is a flow to debt and equity. EV/EBITDA can be
expressed by the following expression.

𝐸𝑉 𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝+ 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘+𝐷𝑒𝑏𝑡−𝑐𝑎𝑠ℎ & 𝑐𝑎𝑠ℎ 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠

= (31)
𝐸𝐵𝐼𝑇𝐷𝐴 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡,𝑡𝑎𝑥𝑒𝑠 ,𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛

P/E and EV/EBITDA are both used a lot to evaluate a company. However EV/EBITDA is
more appropriate to use when comparing companies with different financial leverage as
unlike the EBITDA, EPS is post interest indicator. One of the problems with the P/E
valuation is that EPS can be negative. EV/EBITDA is a good substitute for it, because usually
EBITDA is positive (Damodaran, 2006).

33
PART II: INDUSTRY ANALYSIS
3. Airline Industry
The analysis of specific companies begins with global industry analysis. The first part of
this chapter will be about the low-cost airline industry and characteristics of it. This part
covers the main differentiation features of low-cost airlines. In the Second part, a brief
introduction and current situation of two airlines under the consideration of this thesis will
be described.

3.1 Industry Overview

As the goal of this work is to concentrate on low-cost airlines particularly Ryanair and
EasyJet it is useful to have an understanding how this industry works and how they offer low
fares for flights.

Low-cost airlines are known for offering low fares and having a competitive cost advantage
over full-service carriers. There are a lot of definitions for low-cost airlines. One of them,
offered by European Travel Network states:

“An airline is recognized as a low-cost carrier if at least 75% of their seats are sold at their
lowest published fares or if they offer a very good deal” (Zwan, 2019).

To achieve the competitive advantage LCCs usually build a more simple business model.
Some characteristics of that kind of business model are listed below (Gross, 2007).

 Better use of airplanes: discounters fly from point to point, so they are not tied to a
specific time of arrival at the airport and can fly more often, reducing costs for each
hour of flight, however, there are one or two airports called “bases” from which
LCCs flights start their routes.
 Secondary Airports: To avoid high landing taxes and handling fees LCCs usually
operate out of secondary airports. In addition, this kind of airports is less congested.
 A single type of aircraft: LCCs often times use one type of aircraft and single
passenger class. This is done to have fewer maintenance costs, staff training and
higher efficiency of the crew.

34
  No frills service: LCCs usually do not offer additional services as a choice of seat,
lounge services at airport or meal on board. In addition to this, tickets are not
refundable.
 Less staff - the simpler the business, the fewer people required to run it.
 Fewer reservation costs: Almost all the reservations are done via internet or by
telephone. Thus costs connected to travel agencies and commissions paid to them are
minimized. Moreover, there is no compensation whenever the flight is delayed or
cancelled.

3.2 History of Low Cost Carriers: Ryanair and EasyJet

Starting from 1993 the European aviation market has achieved market liberalization. The
deregulation process made the market more efficient with more affordable air travel.
Moreover, this process caused a growth in the competitiveness of the industry and
encouraged the entrance of low-cost airlines. The first company which used low-cost airline
business structure was Southwest airlines (SWA) from the USA. The first flight price of it
was 20$ (1971). Southwest airlines declared itself as a low-cost airline and did only short-
haul flights, close to 600km, to keep the costs and thus the fares low. Gradually it started to
arrange flight not only within Texas but all over the USA. Later all the other low-cost airlines
built their business model on its example. In Europe firstly Ryanair and then EasyJet were
the initiators (Belobaba, Odoni and Barnhart, 2016).

Ryanair
Ryanair is an Irish low-cost airline based in Dublin, Ireland. It is now the largest low-cost
airline in Europe. It offers more than 2000 flights daily from 86 base stations and more than
1800 routes across 37 countries and 215 destinations. Main bases at Dublin Airport and at
Stansted Airport in London. Currently, it has about 13000 employees.

Historical overview
Ryanair has a rich history that dates back to 1985 when it was a company founded by the
Ryan family. At that time, it had a share with a value of one pound and had 25 employees.
The first line was launched in July 1985 from the Irish city Waterford to London Gatwick
Airport, and during the first year Ryanair operated on this route with five thousand

35
passengers. The initial intention was to disrupt the monopoly held by the companies British
Airways and Aer Lingus on the routes between Ireland and Great Britain. One year later, the
second line from Dublin to Luton Airport in London was added and the number of passengers
transported reached to 82000. In 1988, the carrier expanded its operations by opening two
lines from Dublin to Brussels and Munich. In the early 1990s, Ryanair had hard times, with
a loss of £20 million and a restructuring of the company was necessary. As it was already
mentioned it was inspired by the model of low prices of Southwest Airlines. At the same
time, there were changes in management and under the new structure, Ryanair was profiled
as the first low-cost airline in Europe. In 1995, Ryanair overtook Aer Lingus and British
Airways and became the largest carrier on the Dublin - London route. Ryanair got a great
opportunity with the deregulation of the European air transport market in 1996, which
enabled the company to start operating lines between European states and quickly expand. In
2000, the largest online reservation system in Europe was launched. In August 2001 for the
first time in the history of the company, million passengers were transported within a month.
In 2002, after Charleroi airport in Brussels, Ryanair opened another European base at
Frankfurt Hahn Airport, which meant the end of a monopoly position for Lufthansa, who had
dominated until then. A year later, Ryanair has taken over the loss-making airline Buzz and
became the largest airline operating at Stansted Airport. This year, the company also
exceeded 2 million transported passengers within one month. Three years later, a 4-million
border has already been broken, which made the company the first in the world.
(Corporate.ryanair.com, 2019).

Economic overview

For the 3rd quarter of FY2019, meaning by December 31st 2018 Ryanair reported a net loss
of €20 million. Though the company had a strong traffic growth (8 %) they also had a decline
in aviation fares (6%) offering customers record low prices. Ancillary revenue growth
reached 26 %, however, it was offset by higher costs of fuel and staff.

Revenue

For the third quarter of FY2019 Ryanair had an increase in revenue (9%) and reached to €1.3
billion, which is almost 1 million per passenger. This growth mainly was due to the increase

36
in ancillary revenue and the increase in traffic. As it was mentioned before traffic growth can
be explained by lower fare prices (less than €30), which happened due to the excess capacity
in Europe. As for the ancillary revenue, the company had a growth in priority boarding and
reserved seating. In addition, Ryanair is working on the improvement of company’s digital
platform which will improve the personalization of passengers and hopefully increase the
revenue.

Cost leadership

As the first low-cost carrier in Europe, Ryanair has the lowest unit costs in the EU market.
They have announced 2019 as a year for investing in staff, system and in business as they
aim to reach up to 200 million passengers per year until 2024. In Q3 costs (excluding fuel)
have grown by 6 %, this growth is because of higher staff costs, including pilots’ wage
increase by 20 %, pilot and cabin crew training costs and growth of workers in engineering.

Balance sheet

Having a rating of BBB+ Ryanair’s balance sheet is one of the strongest among peers. They
have €2.2bn gross cash and 93 % owned fleet. For the first 9 months of the year they have
generated €560m net cash from operations and spent €1.2bn on capital expenditures, have
bought back shares from shareholders €560m in value, and paid over €230m from the debt.

Laudamotion

By the end of the 2018 Ryanair finished the acquisition of Laudamotion by acquiring the
remaining 25 % of the Austrian airline. This company has gone through tough times because
of expensive aircraft leases, low fares and unhedged fuel costs. However, the situation of this
airline is improving and it is ready for the second year of operation with 25 aircraft and traffic
growth to 6M passengers (from 4M prior year).

Competition and consolidation

A lot of airlines in Europe have closed some bases because of overcapacity in the European
market which leads to lower fares and because of high fuel costs. Ryanair closed bases in
Bremen and Eindhoven and cut aircraft numbers in Niederrhein and Hahn
(Investor.ryanair.com, 2019).

37
EasyJet
EasyJet is a British airline based at London Luton Airport. Currently, this carrier serves the
largest European transport network and takes the leading position in the Top 100 European
routes and 50 largest European airports. At the same time, it is the 2nd largest low-cost carrier
in Europe with a 12.7% market share. The company operates over 979 regular flights from
156 airports in 33 countries. EasyJet employs over 10000 workers, including 2865 pilots and
6516 cabin crew members.

Historical overview
The EasyJet low-cost airline was founded in March 1995 by Stelios HajiIoanna. Thanks to
the successful strategy company has taken a very significant position in the market very
quickly. The very first flight was taken from London Luton Airport to Scotland's Edinburgh
and then to Glasgow. In 1998, the company bought 40% of the Swiss charter operation, TEA
Basel AG, later renamed “EasyJet Switzerland” In 2002 EasyJet bought the low-cost airline
“Go” operating at Stansted Airport, originally founded by British Airways. The following
year, EasyJet started operations of the first Airbus A319 aircraft to Geneva. In 2004, EasyJet
Inc. first took advantage of the enlargement of the European Union and launched new lines
to Hungary and Slovenia. In 2007, EasyJet moved its management to Luton Airport, where
it is based today. One year later the acquisition of the airline GB Airways, which was based
at the airport Gatwick and operated to many destinations in southern Europe and North
Africa, was completed. Thanks to this acquisition EasyJet significantly strengthened its
dominant position at Gatwick Airport. In 2009 already the company had more than 400
regular flights with more than 175 aircraft in 27 countries. In 2011 the company announces
two new bases in France at Nice and Toulouse. In March 2012 EasyJet launches new base at
Southend airport in London. In the same month of the following year, EasyJet celebrates the
first flight from London to Moscow. Later the airline continued to expand its business in
Europe with new bases and routes.

Economic overview

Based on the Quarterly report of EasyJet the 3rd quarter of the year 2018 was good for the
company with high customer demand and ancillary revenue. EasyJet overall had on-time
performance during the year with exception of the breakdown because of the incident in

38
Gatwick airport, London, when lots of flights were cancelled after the reports of
drone sightings close to the runway

Revenue

By the 31st of December 2018 (which is the Q1 2019FY) the total revenue of EasyJet
increased by 13.7 % and reached to £1296M. From the total revenue, the passenger revenue
was £1025M increased by 12.2 % and the remaining £271mln was ancillary revenue which
had grown by 19.9%.

Passenger numbers

The number of passengers in this quarter was 21.6million, increased by 15.1%. This growth
was due to the increase in capacity (18.2% up to 24.1mln seats). However, it is less than it
was planned, because of the incident in London Gatwick airport (mentioned before) and
because of belated deliveries of A321 aircraft from Airbus.

Despite the growth of total revenue, the revenue per seat decreased by 4.2 % for the 1st quarter
of 2019. The change was driven by:

1. Increase in underlying revenue per seat (1.5%) driven by increasing brand recognition
of EasyJet and an increase in ancillary revenue driven by more sales of additional
baggage permission and preferred seat booking.
2. Negative events affecting the revenue per seat include
 EasyJet flew to Berlin Tegel for the first time this year, thus has no optimal
schedule for that flights yet.
 Benefits that the company had last year weren’t valid for this year. For
example, the closest competitor Ryanair had winter flight cancellations last
year.
 New accounting standards which delayed the recognition of revenue
 And finally, Gatwick case which led to a lot of cancelled flights and
consequently loss in revenue.

39
Costs

Overall cost performance of the company for the 1st quarter of 2019 fiscal year was close to

excepted result before the incident in Gatwick airport. The cost per seat (excluding fuel) had

risen by 1 %. Reasons for this increase are:

1. 400 flights have been cancelled because of the drones in Gatwick airport and thus

costs had risen by £10mln.

2. Increase in crew costs.

3. Costs connected to new aircrafts’ delivery and new accounting standards.

EasyJet records 81 % on-time performance for this quarter, despite the drop in these statistics
because of Gatwick case. The company experienced 764 cancellations in Q1 2019 compared
to 1051 cancellations during the same time of the previous year (Corporate.easyjet.com,
2019).

40
4. Internal Analysis

This section represents the indicators which have a huge influence in any airline’s
performance. Those expressions are ASK (available seat kilometres), RPK (revenue
passenger kilometres), cost per seat and load factors. The analysis examines Ryanair’s and
EasyJet’s key performance indicators (available in annual reports) compared with their
competitors in the industry. The graphs will be added to the study to show the historical
development.

4.1 Available Seat Kilometres (ASK)

ASK shows the passenger capacity of the particular airline. It is calculated as the number of
seats multiplied by kilometres flown (Iata.org, 2019). In other words, this indicator is
showing how effectively the company is using its capacity on every flight.

𝐴𝑆𝐾 = 𝑑𝑖𝑠𝑡𝑎𝑛𝑐𝑒 𝑓𝑙𝑜𝑤𝑛 ∗ 𝑠𝑒𝑎𝑡 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒

Figure 1: Available Seat Kilometres for Four LLC’s

ASK
200000

150000

100000

50000

0
2013 2014 2015 2016 2017 2018

Ryanair EAsyJet Norwegian Wizz air

Source: Own Creation based on Companies’ Annual Reports

As it is visible in the graph, Ryanair had and still has the highest ASK for the last 4 years
compared to the closest competitors in the industry. Moreover, Ryanair had a sharp change
in this indicator for the last 2 years around 12 % and 7 %. EasyJet comes next in terms of the
available seat kilometre, and the change of this indicator for EasyJet was relatively stable 9

41
% for 2017 and for 2018. Two other peers Norwegian and Wizz Air have been improving the
usage of their capacity for the last 3 years. Norwegian reached close to EasyJet having the
difference in ASK in 1.3 times for 2017. The lowest ASK between peers has the Wizz air
with a relatively stable growth since 2014.

4.2 Revenue Passenger Kilometres (RPK)

A decrease in ASK is not always a negative thing as it can happen because of the cost cutting
of the routes which are bad performing. That is why it is useful to look at RPK, another good
indicator to have a better understanding of airlines’ performance. RPK is revenue passenger
kilometres (RPK) and it shows the total passenger traffic because it is the product of distance
flown multiplied by seats sold (Iata.org, 2019).

𝑅𝑃𝐾 = 𝑑𝑖𝑠𝑡𝑎𝑛𝑐𝑒 𝑓𝑙𝑜𝑤𝑛 ∗ 𝑠𝑜𝑙𝑑 𝑠𝑒𝑎𝑡𝑠

Figure 2: Revenue Passenger Kilometres for four LLC’s

RPK
200000

150000

100000

50000

0
2013 2014 2015 2016 2017 2018

Ryanair EAsyJet Norwegian Wizz air

Source: Own Creation based on Companies’ Annual Reports

Looking at the graph we can see that all 4 companies we consider have seen growth in RPK
indicator for the period 2013-2017. Ryanair’s RPK increased approximately by 9 % in the
fiscal year 2018, due to the growth of available seat kilometres, for the EasyJet, this change
is close to 10 %. These two airlines again have the highest result, however, with the growth
rates, there are far under Norwegian and Wizz air who had 24% and 22 % growth in RPK
for 2017 respectively.

42
4.3 Load Factor
The load factor can be interpreted as the percentage of sold seats and it is calculated as
follows: (Iata.org, 2019)

𝑅𝑃𝐾
𝐿𝑜𝑎𝑑 𝐹𝑎𝑐𝑡𝑜𝑟 =
𝐴𝑆𝐾

It can be derived from the formula that, if the load factor is 100 % all the available seats are
occupied. It means that airlines’ capacity is perfectly utilized and the production level is
optimal. The load factor is a good indicator for a company to measure how successful it was
in managing operations effectively. Almost all the airlines use it in their target settings they
aim to maximize profit per seat, whilst maintaining a high load factor.

As it is visible from the graph, almost all the companies’ load factors have been improved
for the 4th year in a row. Just The Norwegian had a small drop in this indicator for 2017.
However there is no significant change in load factors for either of the airlines and they
circulate between 80% and 90 %, with the highest result of Ryanair 95 %.

The increase of Ryanair’s load factor in the last 4 years from 83 % to 95 % has reduced
emissions per passenger by 13%. The discounted fares offered by this company are due to
the policy which states “load factor active-yield passive”, according to that seat prices are
chosen to guarantee high load factor.

Ryanair’s discounted fares are driven by Ryanair’s “load factor active – yield passive” policy
(described by Ryanair’s CEO Michael O’Leary) whereby seats are priced to ensure that high
load factor targets are achieved. As for the EasyJet, on 15 December 2017, it had an
acquisition of part of Air Berlin’s operations at Berlin Tegel Airport. The new flying program
started on 5 January 2018. As it was predicted, Tegel flying had an impact on indicators such
as load factor, revenue per seat and profit per seat. That is why these indicators were included
in the annual report of the company twice, one before and one after Tegel flying. Including
Tegel, Load factor was 92.9 % and the change was too little 0.3 %, however without including
Tegel the load factor has been increased by 1.0 percentage point and reached to 93.6. In the
graph, we used the result with Tegel flying.

43
Figure 3: Load Factor for four LLC’s

Load Factor
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2013 2014 2015 2016 2017 2018

Ryanair EAsyJet Norwegian Wizz air

Source: Own Creation based on Companies’ Annual Reports

4.4 Cost per Seat

Another important indicator for airlines, especially for the ones who are called low-cost
carriers is the cost per seat. For illustrating the results of this indicator, we have chosen the
two airlines which are under the consideration of this thesis: Ryanair and EasyJet. Cost per
seat here does not include fuel costs.

Ryanair’s cost per passenger has been improving for the last years with €42.62 in the fiscal
year 2017 and € 42.08 in the fiscal year 2018, the most significant factor in this drop was fuel
cost per passenger which changed from €15.95to €14.60 in 2018FY.

As for the EasyJet the results are not that good. The costs per seat increased in 2018 compared
to 2017 by 4.9 %. This change can be a result of exchange rates, underlying cost inflation
and the cost of disruption, which is the cancellation of the flights because of third-party
industrial action activities. Underlying cost inflation includes crew cost inflation, agreed pay
deals, inflation in the costs of regulated airport. Moreover, as it was already mentioned
before, EasyJet acquired a part of Air Berlin’s operations in Berlin Tegel airport. This action
had a controversial impact on the all financial indicators of the airline the cost of a seat, which
was, as we have seen, increased.

44
Figure 4: Cost per Seat for Ryanair and EasyJet

Cost Per Seat

60
(excluding fuel)
50

40

30

20

10

0
2014 2015 2016 2017 2018
Ryanair EAsyJet

Source: Own Creation based on Companies’ Annual Reports

4.5 Number of Passengers

Since 2009, the growth of the number of passengers of the LCC airlines in the peer group
was significant. This development is supporting the statistics which were illustrated in section
1.2 of this chapter, namely the leisure travellers are more and more preferring LCC airlines
over the more expensive traditional carriers, because of their growing price-sensitivity. This
section, however, does the comparison inside the peer group of 4 main LCCs.

Figure 5: Number of passengers for four LLC’s

Number of passengers
140
120
100
80
60
40
20
0
2014 2015 2016 2017

Ryanair EAsyJet Norwegian Wizz air

Source: Own Creation based on Companies’ Annual Reports

45
As it is shown in the graph all four carriers had a slow but increasing trend in the number of
passengers for the last 4 years.

Ryanair’s 13 % increase in the number of passengers from 106.4 million to 120.0 million in
2017 partially offset the passenger revenue decrease which was caused by the decline of
average fare from €46.67 to €40.58.

EasyJet has had 9.7 % and 10.3 % growth in the number of passengers for 2017 and 2018
respectively, reaching 88.5 million passengers for 2018.

4.6 Ancillary Revenue and Fleet Analyses

The last two indicators that will be examined for Ryanair and EasyJet in the frame of internal
factors are Ancillary Revenue as an Operational Value Driver and Fleet analysis. Ancillary
revenue represents all the additional services passengers can add while purchasing an airline
ticket. It does not include on-board purchases. Example of ancillary revenue can be seat
reservations, fees for baggage, accommodation services, airport transfers, etc (Cook and
Billig, 2017).

Ryanair offers various ancillary services. For example accommodation services which are
offered on its website. It currently has a contract with four providers (Hotels.com.
Hotelopia.com, HRS.com, Evivo and Hostelsclub). The commissions that the company gets
for it are then reinvested in the same business by giving credits to people who booked
accommodation via Ryanair’s website. It also offers airport transfers, parking services and
travel insurance, as well as ‘Ryanair Holiday’ package, including flights, accommodation
and transfers. Ancillary revenues were 28 % of the total operating revenue for 2018 and 27
% in 2017 (Corporate.ryanair.com, 2019).

The positive change in ancillary revenue of EasyJet which grew by 22.7 %, let the company
offer more attractive products and innovative ancillary solutions. Such as new baggage
pricing laws which can reflect the demand better or improvement in the website to make
ancillary products’ adding easier for the passengers (Corporate.easyjet.com, 2019).

Ryanair is doing the business with more than 440 Boeing 737-800NG aircraft, each of them
with 189 seats and with an average fleet age of 6.7 years. Based on the annual report of the

46
company they are planning to grow to 585 aircraft by March 2024 (Corporate.ryanair.com,
2019).

In contrast, EasyJet operates a fleet of Airbus A320 family aircraft. For the fiscal year 2018,
the company had 315 aircraft compared to 279 in 2017. All A320 aircraft are equipped with
186 seats and have on average 7 years fleet age (Corporate.easyjet.com, 2019).

47
5. Macroeconomic Factors
The essence of the industry analysis is the study of the influence macroeconomic factors have
on the market prices of specific equity instruments. As the selected companies are based in
the European Union (Ryanair, EasyJet) the analysis will address the development of
macroeconomic indicators in these areas. Their dynamic is important because each of the
factors that will be discussed is directly or indirectly connected to the financial performance
and overall operation of the airlines. The study will be enriched with descriptive data.

5.1 Real Output of the Economy

The first of the characterizing macroeconomic factors is the real output of the economy,
which in practice is most commonly described through a gross domestic product (GDP).
There is a positive relationship between the development of the economy and the
development of stock markets in the long run. However, in the short run decreasing stock
prices stimulate investment into companies which increase the real output of the economy.

The development of the real output of the economy can, therefore, be described in the
following graph, which shows the growth of Gross Domestic Product since 2006.

Figure 6: Real GDP growth rate (European Union)

GDP growth

4
2
0
-2
-4
-6
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Series1 3.348493.080160.48328 -4.3487 2.100571.70583 -0.4165 0.257621.749492.314741.96632 2.4488

Source: Own Creation based on IMF database

As the graph shows there is more or less stable GDP growth in the European Union for the
past years with the average growth rate of the economy rising to the level of 2%. GDP growth
rate can be a good indicator for further stock analyses as it is a good approximation for the

48
rate of growth in valuation models. Moreover, one of the characteristic of airline industry is
its dependence on economic cycles. Overall spending in the economy is usually being cut
during recessions and airline tickets are not exception. In contrast during prosperity people
tend to travel more and spend more.

5.2 Inflation
The next of the analysed macroeconomic factors is the rate of inflation. Inflation is assumed
to have a negative impact for the value of stock in the long run. Inflation lowers the
purchasing power of all the goods and services including dividends. They cannot increase at
the same speed as prices and thus the income-generating stocks become less attractive during
high inflation times. Moreover, the taxation on dividends adds another negative effect.

Looking at the chart below (figure 7), we can see the rate of inflation in the European Union
for period 2008-2018. The increase, which is expected in upcoming years,
(Tradingeconomics.com, 2019) will have a negative impact on the intrinsic value of the share,
as inflation will increase the required rate of return for investors.

Figure 7: Inflation, consumer prices (annual %) in EU

Inflation (annual growth %)

4.50000000
4.00000000
3.50000000
3.00000000
2.50000000
2.00000000
1.50000000
1.00000000
0.50000000
0.00000000
-0.50000000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: Own Creation based on IMF database

There are products, the price change of which can affect the airlines as a consumer. One of
these products is jet fuel. Jet fuel price is the largest component in the airlines’ costs. Thus
their dynamic is important while analysing airline industry. In Figure 8 monthly price of jet
fuel is introduced.

49
Jet fuel costs mostly fluctuate because of oil prices. As it is shown in figure 8 the period from
2014-2017 was beneficial in terms of expenses for airlines, this time is known for a
significant drop in oil prices while the economy was strengthening during this time which
led to increasing demand for flights. Fuel costs are estimated to be 10% to 12 % of operating
costs for airlines. Thus they need to be hedged. A good hedging strategy can be buying future
contracts which convert variable jet fuel costs into fixed costs. This is mostly the strategy
adopted by airlines.

Figure 8: Jet Fuel monthly price -US dollars per gallon

Jet Fuel Price

3.5
3
2.5
2
1.5
1
0.5
0
May

May

May

May
Mch

Sep

Mch

Sep

Mch

Sep

Mch

Sep

May
Mch

Sep
Jan 14

Jul

Jan 15

Jul

Jan 16

Jul

Jan 17

Jul

Jan 18

Jul
Nov

Nov

Nov

Nov

Nov
Source: own creation based on data from https://www.indexmundi.com

For 2019 the downside trend of jet fuel prices promises lower cost for airlines and thus higher
revenues.

5.3 Money Supply

The actual value of shares is also affected by the current money supply. The increase in the
amount of money in the national economy will result in an increase in demand for shares and
eventually increase in stock prices. This connection has some theoretical explanations:
(Cfainstitute.org, 2019)

 Liquidity effect - a sudden increase in money supply will give investors a greater
sense of wellbeing, so they invest some of the additional funds in shares.

50
  Transmission Mechanism - Similarly, investors will have surplus funds that are
invested in the bond market. Greater demand will cause a fall in bond yields and
investors will, therefore, move to stock markets.
 Indirect transmission mechanism - money supply growth will decrease interest rates.
Lower interest rates stimulate corporate investment activity, resulting in higher
profits, higher dividends and higher share price

All of the above explanations lead to the same conclusion, namely that money supply growth
stimulates demand for shares.

The graph below describes a quarterly change in broad money (M2+M3+M4) for the period
commencing in 2013. From the increasing trend, which is visible in the graph, we can
conclude money supply growth will lead to higher share prices in 2019.

Figure 9: Broad Money (Euro Area)

Broad money
14,000,000.00
12,000,000.00
10,000,000.00
8,000,000.00
6,000,000.00
4,000,000.00
2,000,000.00
0.00
Q4 2015
Q1 2013
Q2 2013
Q3 2013
Q4 2013
Q1 2014
Q2 2014
Q3 2014
Q4 2014
Q1 2015
Q2 2015
Q3 2015

Q1 2016
Q2 2016
Q3 2016
Q4 2016
Q1 2017
Q2 2017
Q3 2017
Q4 2017
Q1 2018
Q2 2018
Q3 2018
Q4 2018

Source: Own Creation based on IMF database

5.4 Currency Risk

Currency exchange fluctuations can influence airlines in a number of ways. First of all, it is
the difference of currencies in which the operating revenues and costs of the company are
generated. As air tickets can be bought in different currencies, companies have to convert
them later and thus the revenue they generate is subject to currency risk fluctuations. Another
area where airlines are facing the currency risk is borrowing costs, they might be stated in a

51
different currency. For instance, when the domestic currency appreciates the cost of foreign
denominated debt will be reduced. The latter pattern is visible for Euro per GBP in 2018-
2019, Euro per GBP rate has a declining trend. In case of Ryanair, the company’s
headquarter is located in Ireland, however, a lot of operations are taking place in the UK, so
the company has a huge portion of assets, liabilities as well as operating revenues and
expenses in pound. In addition to this, a lot of costs such as ones connected to fuel, aircraft
or insurance are in dollars. To hedge currency risk airlines usually are engaged in derivative
contracts, however, no strategy can totally eliminate the risk. EasyJet also faces the currency
risk problem, as having headquarter in London it operates in more than 30 countries.

5.5 The “Brexit” Referendum

The beginning of the process of the UK leaving the EU can adversely affect airlines working
in both countries. This process will bring with it a lot of uncertainty connected to further
regulations: movement between UK and EU, employment laws, tax rates for EU member
state entities operating in the UK, etc. Since the referendum Pound sterling deprecated by 6
% against the U.S. dollar and 15 % against the euro. (IMF, 2019) So any company getting
revenue in the pound will see the adverse impact of it. Ryanair and EasyJet are two of this
kind of companies. In addition to this, Brexit also can bring new regulatory challenges. U.K.
can keep or change some EU laws and regulations, which will require additional effort from
airlines operating in both countries. Ryanair is a subject to Brexit-related risks as almost 24
% of its revenue from the fiscal year 2018 came from the UK. The risk of “no deal” Brexit
is still high for Ryanair. The company ensures all the shareholders that they have taken all
the necessary steps to protect the business in case of “no deal” Brexit: they have got an air
operator certificate from the UK for the three UK routes and they have put restrictions on the
rights of shareholders who are non-EU. The latter is done to keep Ryanair as EU controlled
carrier (Corporate.ryanair.com, 2019).

52
Figure 10: Exchange Rate Euro per GBP

Exchange Rate (Euro per GBP)

1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00

Source: Own Creation based on IMF database

EasyJet had almost £7 million Brexit-related costs for the fiscal year ending 30 September
2018, which is explained by a re-registration of aircraft in Austria (Corporate.easyjet.com,
2019). This is one of the reasons the company claims it is well prepared for Brexit. Now they
have 130 aircraft registered in Austria. In the case of “no deal” Brexit, the flights between
the UK and EU will continue to be operated. EasyJet also tries to eliminate some of the rights
of non-EU shareholders by putting restrictions on their ability to vote at meetings or/and
selling the shares.

To summarize, several global trends have been identified in macroeconomic factors that will
affect the stock price.

 The positive impact on the share prices will be predicted because of a steady growth
in global economic output, a steady increase in money supply and appreciation of
Euro against GBP.
 The negative impact can be because of the moderate growth of inflation and Brexit
uncertainties.

53
 6. Competitive Environment
The competition in airline industry is believed to be quite strong. Carriers mainly compete
on prices, punctuality, service quality, safety and customer loyalty. This chapter will
concentrate on competitive environment in low cost airlines’ industry. Low cost airlines
started to operate more than 40 years ago. It was Southwest Airlines that was established in
1971. Now this market is significantly different from that time, there are a lot of LCCs who
operate in all over the world. The number of seats offered by LCCs in Europe has been
changed by 124 % since 2009, from 224.29 million seats to half a billion in 2018. Figure 11
represents European low cost market from 2009 to 2018, particularly annual seats during that
time (Worldwide, Official aviation guide, 2019).

Figure 11: Annual seats in millions and year-on-year growth

Annual seats
560
520 501.83
467.05
480
440 419.01
30.0%
400 372.9
360 329.32
320 297.39 13.2% 12.4%
9.3% 281.94 10.7% 11.5%
280 263.19
245.07 7.4% 7.4%
224.29 7.1%
240 5.5%
200
160
120
80
40 1.0%
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

seats growth

Source: self -creation based on https://www.oag.com

Based on the data from the figure 11 the highest growth in LCCs was during 2014. On
average every year LCCs capacity grow in 9.4 %.

To show how LLCs affect the airline industry, what market share they have and how it has
changed during the time figure 12 is illustrated. We can see a worthwhile growth of low cost
airlines. In 2018 their market share was 36.3 %. Which is the highest so far. As in the previous

54
table, here also the share is calculated based on the low cost seats flown in Europe. Ryanair
and EasyJet are still the two largest low-cost carriers in Europe.

Figure 12: Market share of low cost airlines and others

Market Share of LLCs and FCCs

120

100

80
64.5 63.7
60 76.1 75.2 74.3 72.6 71.8 70.1 67.8 66.1
40

20
35.5 36.3
23.9 24.8 25.7 27.4 28.2 29.9 32.2 33.9
0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Low cost market share other market share

Source: self-creation based on https://www.oag.com

In the following pie chart (figure 13) top 10 biggest low cost carriers are listed. According to
the seat capacity Ryanair is the leading low cost carrier in Europe with 139 million seats and
30% of market. The closest competitor of it is EasyJet which is close to the barrier of 100
million seat capacity. Next come Norwegian and Vueling with 9% and 8% of market share
respectively. The top 10 closes Sun Express which had a big growth lately and replaced
Spanish LCC Volotea in top 10. The latter is now the 11th in seat capacity ranking.

55
Figure 13: Europe's top 10 Low Cost carriers (annual seat capacity in millions in 2018)

13.54 9.19
16.02

32.4
139.06
36.27

36.48

39.15
98.44
42.36

Ryanair EasyJet Norwegian Vueling Wizz Air

Eurowings Pegasus Airlines Transavia Jet2.com SunExpress

Source: self-creation based on https://www.oag.com

Almost the same results of ranking can be detected looking at the figure 14 shows the market
share distribution between low cost carriers again based on seat capacity.

Figure 14: Europe's top 10 Low Cost carriers and their market share

3% 2%
3%

7%
30%
8%

8%
8%

21%
9%

Ryanair EasyJet Norwegian Vueling Wizz Air

Eurowings Pegasus Airlines Transavia Jet2.com SunExpress

Source: self-creation based on https://www.oag.com

56
7. Partial Conclusion

SWOT analysis
After examining the internal, macroeconomic and competitive environment of Ryanair and
EasyJet it is important, for further analysis, to have an overview what are the strengths,
weaknesses as well as upcoming opportunities and threats these two companies have. This
kind of conclusion is known as SWOT analysis. The four categories should be analysed based
on the previous information introduced before in this part of the work. The external analysis
provides information about the opportunities and threats the airline is facing, in contrast, the
internal analysis helps to evaluate the performance, utilization, growth and efficiency
companies have, and thus helps to report about the strengths and weaknesses of Ryanair and
EasyJet.

Strengths
Competitive advantage in costs still remains one of the strengths Ryanair has. It was
announced as the 11th Best Low-cost Airline in the world in 2018 voted by the travellers and
according to Skytrax it was the 4th best low-cost carrier in Europe in 2018. (SKYTRAX, 2019)
As a very large carrier, Ryanair has a power in bargaining against its suppliers, which is
another chance to control costs. A strong financial performance is one of the most important
factors for a business to be called successful, as for the Ryanair it has continued to make a
profit (10 % increase in profit) and is now the most profitable airline in Europe. Another
strength of Ryanair is the good online ticket reservation system via website or the application,
which enables passengers to skip connection with travel agencies and buy tickets themselves.
Furthermore as it was mentioned before the ancillary revenue the company has is growing
due to addition of new services (Corporate.ryanair.com, 2019).

The second airline under our consideration, EasyJet, can be proud of strong brand name it
has, which helped them create customer loyalty and growth. EasyJet is the second biggest
carrier in UK and one of the biggest in Europe. According to Fleming awards (2018) it ranks
first for value for money and is 19 point ahead of Ryanair. Among the strengths of EasyJet
financial strength is one of the huge ones, worth to mention. The company had 15 % increase
in profit for 2018. Due to strong financial results company could acquire air Berlin.

57
Weaknesses

Despite being one of the most successful airlines, Ryanair has a lot of scandals connected to
its service: including acts of racism, drunk people on board, massive flight cancelations, or
strikes by crew. In most of the cases not only the crew could not handle the incidents, but
also later the company’s reactions were not fast and empathetic. Thus Ryanair is famous for
its poor customer service. That is why reputation is one of the weaknesses of the company.
Moreover because of strikes the company is going through a tough time and is negotiating
with unions regarding the payroll of the crew.

One of the weaknesses of EasyJet is not having a lot of flights in global market. The company
is mainly concentrated in Western and Northern Europe and doesn’t have many flights in
Eastern and Central Europe or Asia. Besides, as it was already mentioned in this paper,
EasyJet acquired a part of Air Berlin’s operations in Berlin Tegel airport. For the previous
year this operation increased cost of a seat and had a controversial effect on other financial
indicators of the company. Another negative impact on revenue of the company had Gatwick
case mentioned in chapter 1.

Opportunities

Ryanair has ordered new aircrafts, which will be delivered in next 10 years, this is an
opportunity to improve company’s market position by reducing the negative environmental
impact and by utilization of fuel consumption. Moreover company is considering to widen
its routes by offering long-haul flights with low fares. It has started a new flight from Cyprus
to Jordanian capital’s Queen Alia International Airport in March 2018. They are providing
flights four times a week. According to forecasts this will attract 500.000 passengers per year.
Recently acquired Laudamotion can create another place for new opportunities for the
business with improving performances.

In order to utilize demand opportunities, EasyJet also regularly looks back on its routes. An
example of it is new operating airport (Tegel). During 2018 the company added 150 new
routes and cut 33 not-working routes instead. Besides that, EasyJet is also renewing its fleet
with newly ordered more cost-effective aircrafts.

58
Threats

Despite the new ambitious operations Ryanair is planning, there are several external factors
that are out of its control. This kind of factors are fuel prices, exchange rate fluctuations and
other possible events which may have impact on flights’ demand.

As it was mentioned before both Ryanair and EasyJet will influence from Brexit and currency
fluctuations coming from this revolutionary event. However this influence will be far bigger
on EasyJet being based in UK.

59
Part III: STOCK VALUATION
This part of the thesis introduces our main findings, stock evaluation of the companies under
the scope of this thesis and final investment recommendations. For share price evaluation
two different approaches will be used: absolute and relative valuation methods.

8. Absolute Valuation
Absolute valuation implies that discounted cash flow models will be used to estimates free
cash flows the company can generate and thus the intrinsic value of the share. The most
common method of discounted cash flow approach is dividend discount models, however, it
is not proper to use while evaluating Ryanair’s share price, as the company is not stable in
its dividend policy, it has paid dividends for 4 times in a decade. As for the EasyJet, it has
relatively stable dividend paying history so DDM model will work for evaluating its share.

8.1 Ryanair
Before coming to stock valuation, we would like to analyse stock price movements for the
last 5 years. As it is visible in the graph below, the share price was affected by the income
growth happened in 2014-2015. As a consequence of blossoming economy so-called post-
crisis period.

Figure 15: Ryanair price chart 2014-2019

Source: Yahoo Finance

60
The stock was trading at 7.09 Euro on 10.05.2014 and it reached to 15 Euro on 13.12.2015.
Next pick was in August of 2017 (18.6 Euro) following the growth during the summer period,
explained by seasonal effects and news coming up from the company about expanding profit
based on plans of new aircraft and new routes. End of 2017 wasn’t the best period for the
company with rising fuel prices and staff costs. Throughout 2018 the price of the stock was
fluctuating having tendency to decline mostly because of staff striking and thus cancelled
flights. The company entered 2019 with disappointing profit results, which have been hurt
by lower winter fares, bad weather conditions and air-traffic control strikes. By the end of
the winter, the prices gradually increase reaching 12.28 Euro at the end of April 2019.

Further, the presented analysis has a goal to conclude about the current price of the stock,
whether it really shows the company’s financial strengths/weaknesses, or it is
under/overvalued.

In order to apply models to calculate the intrinsic share value of airlines, it is necessary to
determine some input values which are the required rate of return and the growth rates of
dividends, free cash flows and terminal growth rate.

The required rate of return

To estimate the required rate of return the CAPM model will be used. To do that, one must
first determine three components. The first of the necessary inputs to the CAPM is the risk-
free rate of return. As already mentioned in the theoretical part, usually as the approximation
of the risk-free rate ten-year government bond yield rate is taken. Bloomberg offers 0.911%
as an approximation for risk free rate for Ryanair.

The second input variable in the CAPM model is the market rate of return. Which is then
compared with risk-free rate of return and the difference is known as the market risk
premium. Bloomberg terminal offers 10.083 as an expected market return for the financial
year ending on 29 of March.

The last variable to be estimated for the CAPM model is Beta. The Beta parameter should be
calculated relative to the market portfolio. Professor Damodaran (Damodaran, 2013)
suggests three approaches to estimate beta parameter 1. Historical data approach, 2.
Fundamental approach, 3. Accounting approach. We will use historical data approach within

61
the framework of this paper. Historical data approach is used by most analysts and by most
estimation services like Bloomberg. It suggests doing a regression of the stock returns on
market returns. And the slope of the regression, in this case, will be the beta parameter for
the stock. However not everything is straightforward in this regression, firstly standard errors
should be taken into account to have a more reliable estimate for beta and secondly, there are
three important aspects that analysts should consider for the regression data. Those three
aspects are time period (length of the period taken), market index taken and return interval
(annual, monthly weekly or daily). For Ryanair, Bloomberg terminal offers 1.232 as levered
beta for the financial year 2018 ending on 29th of March.

Having all the inputs of CAPM we can calculate the required rate of return as it was described
in formula 2.

𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 (𝐸(𝑅𝑀 − 𝑅𝑓 )) = 0.911% + 1.232 ∗ 9.172% = 12.21%

Table 2: Assumptions for return on equity calculation.

Assumption Description

Risk Free Rate 0.91% Bloomberg terminal as in April 2nd 2019

Market risk premium (MRP) 9.17%
Beta levered 1.232
Terminal growth rate 1.79%
Corporate marginal tax rate 12.5 %
Source: Bloomberg terminal
Bloomberg terminal as in April 2nd 2019
Bloomberg terminal as in April 2nd 2019
Average GDP growth rate for Europe
Irish corporate tax rate

As we already have the cost of equity calculated we can continue to WACC (weighted
average cost of capital), because, as it was already mentioned in the theoretical part of this
work, it will be used as required rate for FCFF calculation. Now coming back to 5th Formula
of the work we can easily find out WACC. Based on the Bloomberg terminal we have the
cost of debt as 1%. For the fiscal year ending in 2018 overall debt including capital lease
obligations of the company was €3963 million. So the weights of debt and equity will be
17.5% and 82.5 relatively and we assume that this ratio will be constant in upcoming years.
Tax rate is taken 12.5% as it is the Irish corporate tax rate.

Now we can calculate the WACC for Ryanair for 2019 -2024.

62
Table 3: WACC Calculations

Year 2019F 2021F 2022F 2023F 2024F

Cost of Equity
Risk free 0.57% 0.57% 0.57% 0.57% 0.57%
Market Risk Premium 10.76% 10.76% 10.76% 10.76% 10.76%
Cost of Equity 12.46% 12.46% 12.46% 12.46% 12.46%
Cost of Debt
Cost of Debt 0.80% 0.80% 0.80% 0.80% 0.80%
Marginal Tax Rate 12.50% 12.50% 12.50% 12.50% 12.50%
After Tax cost of debt 0.70% 0.70% 0.70% 0.70% 0.70%
Weight of Equity 76.60% 76.60% 76.60% 76.60% 76.60%
Weight of Debt 23.54% 23.54% 23.54% 23.54% 23.54%
WACC 9.7% 9.7% 9.7% 9.7% 9.7%
Source: Own calculations based on Bloomberg terminal

Growth rate

A substantial role in the valuation of the share is played by an estimate of the future cash
flows the company would generate. The most common method for estimating future cash
flows is the quantification of the growth rate, also referred to as g. The growth rate can be
expressed in several ways: from historical approach, other analysts’ results via expressing g
as a product of retention rate and Return on equity (so-called sustainable growth model) or
via deriving from GDP growth.

The selection is dependent on available data and claims for the necessary explanatory ability
and further use. As it was already mentioned Ryanair is not stable in its dividend paying
policy. That is why out of available discounted cash flow models FCFF method will be used.

When we have historical cash flows they can help us to make a reasonable forecast of future
cash flows. They come out of the income statement, cash flow statement, they are influenced
by the revenues each year, the costs each year and the investment decisions of the firm each
year. Here we should remember where the free cash flow comes from, it is the cash flow
from operations minus the capital expenditures. Looking at the cash flow statement of
Ryanair we can see a significant growth in free cash flows for the last year (almost 60%),
which was followed by a drop the company had in 2017. Now we will need do the research

63
and see where these fluctuations are coming from: if they are coming from revenue growth
or from cost cutting or they are coming from the fact that maybe the firm didn’t have
significant capital expenditures recently that they had in earlier years. Now we will look at
these components one by one and analyse their historical fluctuations and try to come up with
a prediction of their future possible values.

But before that we will look at terminal growth rate. Terminal growth rate will be 3% which
is the average GDP growth rate for Ireland for the last three years. GDP growth rate is a good
approximation for terminal growth rate of company because it is not logical to think of a
perpetual growth rate for a company which is higher than GDP growth rate of the economy
the company operates in. We have chosen the last three years to see the average as we wanted
to exclude all the outliers that can affect the model, and as already mentioned years before
2016 were period of recovery and economy growth, so all the indicators got extraordinary
values for that period.

Income

On the table below indicators such as revenue, earnings before interest, depreciation and
amortization, earnings before interest, net income and their growth rate are illustrated for the
period 2011-2018. We will be examining these indicators to analyse what is happening with
measures showing income and forecasting future values of them. It is visible from the table
that Ryanair, like other companies, had a sharp rise in indicators like revenue, EBIT, and Net
Income from 2014-2015. This happened mainly because of the decline in oil prices and as
Richard Westcott, BBC transport correspondent describes during that year Ryanair had some
new developments (better website, new application) which lead to more passengers. That is
why the forecasting which will be based on historical data will include the results for the last
4 years.

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Table 4: Historical Revenue data and Average results

Year Revenue Growth EBITDA Growth EBIT Growth Net Growth

Rate Rate Rate Income Rate
2011 3,629,500 765,900 488,200 374,600
2012 4,390,200 20.95% 992,400 29.57% 683,200 39.94% 560,400 49.60%
2013 4,884,000 11.24% 1,047,800 5.58% 718,200 5.12% 569,300 1.59%
2014 5,036,700 3.12% 1,010,400 -3.56% 658,600 8.29% 522,800 -8.17%
2015 5,654,000 12.25% 1,420,500 40.58% 1,042,800 58.33% 866,700 65.78%
2016 6,535,800 15.59% 1,887,200 32.85% 1,459,900 39.99% 1,559,100 79.89%
2017 6,647,800 1.71% 2,031,500 7.64% 1,534,000 5.07% 1,315,900 15.60%
2018 7,151,000 7.56% 2,253,300 10.91% 1,692,300 10.31% 1,450,200 10.21%
Arithmetic 10% 18% 17% 21% 18% 26%
mean
Geometric 10% 17% 19% 21%
mean
Standard 6% 15% 23% 35%
deviation
Arithmetic 9% 23% 28% 35%
mean(2015-
2018)
Source: own calculations based on annual reports

As it was mentioned in the second part of this thesis, Ryanair aims to reach up to 200M
passengers per year until 2024. This number can be a good indicator for us to evaluate other
parameters. Having 129.8M passengers throughout 2018, the company needs to have 55%
growth in passengers’ numbers during the upcoming 5 years to achieve the goal set. For
simplicity we will assume that to reach the desired number the company will go in a linear
growth path, which means every year it will need to have a growth in passengers’ numbers
by 7.75%. As for the fares, company aims to keep its lowering fares strategy for the future.
Based on the annual report of Ryanair we can come up with an assumption that they are going
to try to keep the reduction in average fairs by 1 %. Considering the former information about
passengers and average fares it was possible to make a prediction of the scheduled revenues
of the company (the production between the forecasted number of passengers and average
fare). Scheduled revenue increased by 5 % in 2018 reaching 5134 million. This happened

65
because of two components: the increase in passenger number by 8 % and the decrease in
average fare by 3%. Operating revenue, in general, includes Scheduled revenue and ancillary
revenue. For Ryanair, this proportion is 72% scheduled and 28 % ancillary revenue. As
Ryanair’s goal setting may tell us they will mostly concentrate to increase the ancillary
revenue rather than the scheduled one. This is because the company aims to reduce the fares
for the future and try to access more revenue via ancillary services. Thus taking into
consideration the above mentioned, we have forecasted 10% growth in operating revenue.
Which is close to the historical average (9%) calculated for 2015-2018.

Operating expenses

There are seven types of operating expenses which are distinguished in Ryanair’s annual
reports. In the chart below these categories and their proportions in overall operating
expenses are shown. Oil and Fuel expenses take the largest proportion of airlines’ expenses,
for 2018 it was 35% for Ryanair. Oil and fuel costs dropped by 8 % for the last year. The
growth of overall operating expenses from 2017 to 2018 was 27 %, it mainly happened
because of increase in airline connected costs, such as staff costs, airport and handling
charges, route charges, etc.

Figure 16: Operating Costs of Ryanair in 2018

3% 1%

7%

10% 35%

13%

13% 17%

Fuel and Oil Airport and handling charges

Staff costs Route charges
Depreciation Marketing, distribution and other

Source: Ryanair’s annual report

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Coming back to fuel costs, it is hard to predict it correctly, so it is one of the challenges for
the company to keep fairs low in case of rising fuel costs. However, we can assume an
increase in overall fuel prices as a result of a shortage in petroleum reserves among suppliers.
Furthermore, fuel prices are quoted in U.S. dollar, so Ryanair faces also exchange rate risk
connected to oil and fuel purchase when the dollar appreciates against Euro. To moderate the
risk of price fluctuations Ryanair enters into forward contracts covering periods up to 18
months.

Staff costs (salaries, wages and benefits) increased in absolute terms by 17%, however, in
per passenger terms, the change is not that much (7%) this difference can be explained by the
growing number of passengers, routes and airports.

Depreciation costs where 4 % more previous year compared to 2017 and it is reasonable
taking into account 55 new aircrafts the company had purchased.

All the costs mentioned above (depreciation, staff and fuel charges) are expected to increase
as Ryanair considers broadening the business, getting into new countries and airports so new
aircraft and flights equipment, including staff, will be required.

Maintenance, materials and repairs are mainly about the costs the company does to maintain
the provision of leased aircraft. It decreased by 3% in per passenger terms but increased 5%
in absolute terms. This indicator is expected to grow as a result of Ryanair’s aircraft
expansion and replacement plan.

In per passenger terms, airport and handling charges, as well as route charges, stayed
relatively flat, however, they have been changed in absolute terms reflecting passenger
number change by 9% and change is sectors flown by 7%.

Marketing and distribution costs increased in 2018 by 17% which can be connected with
scandals around the company, flight cancellations and thus their goal to recover their
reputations, and their aim to increase ancillary revenue.

Now when we have examined operating income and expenses we can do some assumptions
about their future movement, as it was already mentioned we would assume that operating
income will have stable growth of 10%.

67
As for the operating expenses, we would forecast them with the help of operating margin
which was in average 22 % for last three years. Operating Margin is one of the key indicators
for evaluating the intrinsic value of the share. For airline industry, it is a subject to
uncertainty, because of its high fixed costs and highly elastic revenues. As the fixed costs are
higher the operating costs from each flight do not fluctuate much with the additional
passengers. Thus a small change in the number of passengers or fare pricing can significantly
affect the financial results of the company.

Our assumption is that the strategy which is adopted by the board will maintain operating
margin relatively stable for the upcoming years then it will gradually grow to reach up to 25
% for 2024. One of the reasons why we have predicted this growth of operating expenses is
the prediction for oil prices movement offered by U.S. energy information administration
(Eia.gov, 2019), based on that oil prices will have a sharp growth for 2019 and 2020, while
later on, this growth would be rather calm and smooth. As for the other costs we predict that
staff costs will continue to grow connected to the goal of the company to add passenger
numbers. Costs connected with maintenance, materials and repairs will be milder in our
opinion because of the new delivery of 25 Boeing 737 MAX 200 which will reduce fuel
consumption up to 16% and will offer 4% more seats per flight. (Corporate.ryanair.com,
2019). Other costs like marketing, advertising costs are expected to be higher because of the
increasing number of airports the carrier operates in. These are just assumptions, and we
don’t argue that this is the only scenario that can happen, however looking at costs and their
movement for last years and taking into consideration that company still works on lowering
the cost we came up with this forecast of the future operating margin of the company.

Property, plant and equipment

Property, Plant and Equipment or capital expenditures are essential for companies in the
airline industry as they are mostly used in the acquisition of aircraft. Net cash outflow for
capital expenditures in 2018 was €1470 million. Usually, Ryanair buys new aircraft with
funds provided by international financial institutions. In 2018 Ryanair acquired 431 Boeing
737-800 aircrafts almost half of them were funded by Export-Import bank of U.S. They
believe in the company they have enough funds for requirements of capital expenditures for
2019. To find net investments depreciation will be subtracted from capital expenditures. Then

68
we will find out the portion of net investments in revenue, which is on average 13% for the
last three years. For free cash flow calculations, we have chosen capital expenditures as a
fixed portion from revenue: as it was mentioned above it 13 % as an arithmetical average for
last three years and we will assume that this proportion will not change for upcoming 5 years
following the historical path.

Operating net working capital

Operating net working capital is an indicator for the company’s liquidity and it is the
difference between current assets and current liabilities. The fluctuation of this variable is
usually tightly connected to changes in revenue. This correlation is true for Ryanair as well,
as it was mentioned in their annual report. Looking at the balance sheet of the company we
see that it finances its day to day operations by cash generated, bank loans and funds from
transactions in the debt capital market. All the liquid resources the company has by March
31, 2018, were €3,680.1 million compared to €4,140.3 million in 2017. For the €1,470.6
million purchase of property, plant and equipment, the company mainly used the cash
generated from operations. Cash was also used to buyback €829.1 million shares. So the
logical conclusion is the faster company expands the more current assets it will need. Thus
our forecast for net working capital will be based on the revenue changes, in other words, we
predict 10 % growth in net working capital as we did for revenue.

Revenue and Cost forecasts lead to forecasting the earnings before interests and taxes (EBIT)
which is the first component to build free cash flow on. Based on our assumptions regarding
the components of free cash flow of Ryanair from the period between 2019 to 2023 we came
up with the intrinsic value of Ryanair’s share price and it is 14.17 Euro. As for the April 23th
the market price of Ryanair’s share costs 12.28 Euro. So it is undervalued by 13%. Thus a
buy signal is valid here based just on calculations via intrinsic value method. We would avoid
giving any recommendations before trying other models to evaluate the company’s stock.
Which will be done further in this thesis.

69
8.2 EasyJet
Under the scope of this thesis, we will also examine EasyJet, its financial situation, recent
developments and come up with the intrinsic value of this low-cost carrier’s share as well.

Figure 17: EasyJet price chart 2014-2019

Source: Yahoo Finance

When looking at EasyJet’s stock price developments for the last five years it is obvious that
the company was much affected with Brexit referendum in summer of 2016. It failed the
most in 12 years after the UK vote for leaving EU. All the economic uncertainties which
followed the Brexit referendum, as well as weakening pound, cost London based company
23% lost in shares. The recovery process from the Brexit referendum started at the end of
2017 and continued in 2018. It was in January of 2018 that EasyJet launched new operations
in Berlin Tegel airport. The increase in share price is also explained by the company’s new
strategy to concentrate on ancillary services which give rise to shares by 4.5%. The next drop
in prices happened in September 2018 as a consequence of growing oil prices. Further stock
price fluctuations were again because of Brexit uncertainty coming from Teresa May’s
announcements about possible delaying the vote of Brexit. Since then all the other
fluctuations are coming from uncertainty around fuel prices, capacity and Brexit.

We will build our forecasts based on soft Brexit assumptions, meaning that we will assume
EasyJet is ready for that with its new established post-Brexit EU base: Vienna.

70
In contrast with Ryanair, EasyJet has more stable dividend paying policy, as they have paid
dividends for last 7 years (table 5), however the dividend per share is different each year and
there is no noticeable pattern in their change, so here we would suggest using the dividend
discount model (DDM) without taking historical averages for dividend growth rate, but
sustainable growth rate formula.

Table 5: Dividends paid by EasyJet (2013-2019)

Year 2013 2014 2015 2016 2017 2018 2019

Dividend 0.33 1.28 0.70 0.79 0.67 0.54 0.74
Growth 285% -45% 13% -15% -19% 37%
Arithmetic mean 42%
Source: Own calculations based on annual report

We can see the enormous change in dividends paid by EasyJet for 2014 and 2015 which is
not surprising as we know these years were a period of blossoming for the whole world
economy, and fuel prices were significantly dropped. Taking into consideration this fact and
just looking on the growth numbers it seemed reasonable not to rely on the average change
of dividend paid.

Before coming to growth rate it is important to understand what discount factor we are going
to use for final stock valuation.

As it was done for Ryanair discount factor will be determined using the CAPM model.

Table 6: Cost of Equity Calculation for EasyJet

Assumptions Description
Risk Free Rate 1.573% Bloomberg terminal as in April 2nd 2019
Market risk premium( MRP ) 11.645% Bloomberg terminal as in April 2nd 2019
Beta Levered 0.566 Bloomberg terminal as in April 2nd 2019
Terminal Growth Rate 1.61 % Average GDP growth rate for UK
Cost of Equity 8.16%
Source: Bloomberg terminal

We will choose the average GDP growth rate in the UK for last three years (1.61%)
(Excluding post-crisis period) as the terminal growth rate. The logic under this assumption is
the same as we described in Ryanair’s case.

71
To forecast growth rate for any variable, several assumptions must be made. To do that we
will analyse the financial performance of the company to understand what has happened to
it lately and what to expect.

Revenue

2018 was a good year for the company in terms of revenue as it increased by 16.8% reaching
to £5,898 million. As it was already mentioned before EasyJet started to operate in Berlin
Tegel airport and £198 million from the whole revenue of the year was due to this operation.
Both operating and ancillary revenues where strong previous year having 15.4 % and 22.7 %
growth respectively. As for the historical results of income indicators, they are illustrated in
the table below for the period 2010-2018.

Table 7: Historical Revenue data for EasyJet and Average results

Year Revenue Growth EBIT Growth Net Growth

(£) Rate (M) Rate2 Income Rate3
(%) (%) (%)
2010 2973,000 210,000 121,000
2011 3,452,000 16% 269,000 28% 225,000 86%
2012 3,854,000 12% 332,000 23% 255,000 13%
2013 4,258,000 10% 497,000 50% 398,000 56%
2014 4,527,000 6% 583,000 17% 450,000 13%
2015 4,686,000 4% 689,000 18% 548,000 22%
2016 4,669,000 0% 501,000 -27% 427,000 -22%
2017 5,047,000 8% 427,000 -15% 305,000 -29%
2018 5,898,000 17% 593,000 39% 358,000 17%
Arithmetic Average 9% 17% 20%

Geometric Average 9% 14% 15%

Standard Deviation 6% 24% 35%

Source: Own calculations based on annual reports

Despite the growth in revenue, costs have increased as well. It mostly happened because of
inflation and unexpected disruptions as well as the late delivery for the aircraft. The huge

72
part of costs, as we already know, is comprised of fuel costs. This indicator increased by
11.5% last year.

Headline costs per seat excluding fuel has grown by 5.3%. Airport handling costs increased
by 2.5 % in per seat terms. Nevertheless, this change wouldn’t be that much if not Tegel
airport costs (0.8%).

On the graph below (figure 4) operating expenses and their proportions are illustrated. As
expected fuel costs are a huge part of the expenses, however, in contrast with Ryanair the
largest portion in operating expenses have airports and ground handling costs. This can be
explained by Tegel airport operations.

Maintenance costs are another big portion of operating expenses with 22%. Next, come crew
costs. Crew costs have risen in 2018 reaching up to 6.4 % higher result. This is explained
firstly by the payroll growth for the crew and secondly by higher retention of the staff for the
summer peak. Around 6% of changes were recorded in maintenance charges and marketing
and distribution costs. The former was driven by more lease contracts returns and higher
prices demanded from suppliers. Marketing costs increased because of the new advertising
campaign including Tegel advertising.

Figure 17: Operating Costs of EasyJet in 2018

Operating Expenses
3% 4%

3% 9% 22%
6%
8%

14% 31%

Fuel Airports and ground handling

Crew Navigation
Maintenance Selling and marketing
Other costs Aircraft dry leasing

Source: Own calculations based on annual reports

Besides above-mentioned headline costs other costs per seat have risen by 22%. This number
is explained by disruption events throughout the year, specifically bed weather conditions in

73
Europe, overloaded airports, traffic control restrictions and in addition to that late aircraft
delivers.

Driven by the growth in revenue total profit before tax increased to £445 million (£385
million in 2017). EasyJet has a fixed dividend paying policy, they pay as a dividend 50% of
their headline profit after tax.

Referring to the formula 14 in the 1st part of this thesis, we will use a sustainable growth rate
as an assumption for dividend growth rate in our calculations and forecasting. The retention
ratio is stable for EasyJet, based on company’s policy of paying dividends, each year’s net
income is equally divided, and 50% of it is invested back in the company to grow the business
(retention ratio), while other 50% is paid to shareholders as a dividend. The next parameter
we will need for growth rate calculation is Return on equity, the portion of net income in
shareholder’s equity. As we were calculating ROE based on historical data, we noticed the
same pattern as already mentioned in this thesis several times, results from 2014-2015 are
outliers in our model, so ROE calculated with them including in historical average
calculations are significantly higher than without them. Namely, we got 21% as average ROE
for the period 2013-2019 and 13% for 2016-2019. For further calculations, we will base our
assumption on Bloomberg estimation of net income for upcoming years and calculate the
ROE to be 8%. This is more reasonable as sustainable growth rate formula is based on
assumption that cost of equity can be a good approximation for the return on equity,
considering the fact that in their mature phase companies can only earn investors’ opportunity
cost of capital. Putting the results in the formula we got a dividend growth rate of 4%.

Having all the required results we can calculate stock value via DDM using formula 12 stated
in the first part of the thesis. Our assumption is that dividends will grow by 4% for the
upcoming 5 years and then by terminal growth rate which is approximated with GDP growth
rate in the UK, as previously mentioned (1.61%). Based on these assumptions we got the
intrinsic value of EasyJet’s share price 12.9 GBP being almost 11% higher than the market
price of the share for 27th of April 11.54 GBP. Thus, the best recommendation will be to buy
the stock. However, here as well we will come up with a final recommendation after the
relative valuation of the stock price.

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9. Relative Valuation
The second approach to evaluate a company is the relative valuation which is based on
financial ratios of peer companies. This method is easier to implement than the discounted
cash flow model, as it doesn’t require any assumptions based on future cash flows company
will generate, but the comparison of similar assets’ prices or historical movement of
multiples. As already mentioned in the first part of this thesis the most widely used ratios
are P/E ratio and EV/EBITDA, these two ratios will be implemented here on yearly basis to
evaluate EasyJet and Ryanair. For the companies being analysed in this thesis, we decided to
take historical median as a benchmark of multiples to come up with price estimate for 2019.

P/E ratio
P/E ratio is the most widely used multiple for relative valuation. It is internally consistent as
both the numerator and the denominator are equity values.

Ryanair’s historic median P/E multiple is 14.5, as for the EasyJet this indicator is 13
(Bloomberg.com, 2019). Now we can apply these results to come up with the target price of
both companies while using the forecast multiples approach to 2019F.The target share price
of Ryanair will be 20.6 Euro (Table 8) The same approach has been used to evaluate
EasyJet’s share price and the result is that target price of EasyJet calculated with average
historical P/E is 11.92 GBP. The formula used in the tables finds the relative values of the
shares based on the historical multiples of the companies.

Tables 8, 9: Price calculations based on P/E (Ryanair, EasyJet)

P/E P/E
Ryanair Profit 2019F 1,611.3 EasyJet Profit 2019F 364.5
Average historical P/E 14.5 Average historical P/E 13
Price of the shares outstanding 23,363.85 Price of the shares outstanding 4,738.5
Shares outstanding 1,133.4 Shares outstanding 397.2
Target Price 20.61 Target Price 11.92
Source: Own calculation based on Bloomberg data

Besides historical median approach we would also like to compare the results of peers in the
industry. However, as we looked at current ratios of the peers we have found negative results
of P/E for Air Berlin and Norwegian Air Shuttle ASA. That is why we would avoid

75
calculating the average mean P/E for the industry, as the sample will contain only three
airlines, namely, Ryanair, EasyJet and Wizz Air.

EV/EBITDA
In contrast with P/E ratio, EV/EBITDA is not affected by the changes in the capital structure.
Again the historical median will be our approximation for forward-looking EV/EBITDA
ratio. Historical EV/EBITDA for Ryanair is 9.48 and 7.5 for EasyJet. As a result we got 11.75
Euro as a target price for Ryanair and 11.42 GBP for EasyJet.

Tables 10, 11: Price calculation based on EV/EBITDA (Ryanair, EasyJet)

EV/EBITDA EV/EBITDA
Ryanair EBITDA 1,821.7 EasyJet EBITDA 735.2
Average historical EV/EBITDA 9.489 Average historical EV/EBITDA 7.5
RY EV 17,286.3 EasyJet EV 5514
RY net debt 3,963 EasyJet net debt 977
RY Equity Value 13,323.3 EasyJet Equity Value 4,537
Shares outstanding 1,133.4 Shares outstanding 397.2
Price target from relative 11.75 Price target from relative 11.42
valuation valuation

Source: Own calculation based on Bloomberg data

EVA (Economic value added)

Another valuation criteria already mentioned in the theoretical part of this thesis is EVA
(Economic Value Added). Looking at the dynamics of this indicator starting from 2014-2018,
we can see the increasing tendency in Ryanair’s results, in contrast to it, EasyJet’s EVA has
declined to 134.1M after sharp growth in 2016. Currently, both have positive result for this
indicator, meaning that the companies are adding value. Whether the tendency will continue
for the upcoming years is hard to predict precisely, however, these results verified our
concerns about EasyJet’s future profitability connected to UK economy uncertainties.

Table 12: EVA for Ryanair and EasyJet in 2014-2018 (in millions)

2014 2015 2016 2017 2018

Ryanair (€) -2,41 -217.58 237.95 502.54 518.78
EasyJet (£) 205.9 326.56 364.29 283.59 134.1
Source: Own calculation based on Bloomberg data

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 Sensitivity analysis
To evaluate equity analysts usually implement a lot of assumptions. In previous chapters, we
did several assumptions to come up with an estimated share price of Ryanair and EasyJet. To
highlight how these assumptions fluctuate equity values sensitivity analysis will be done on
important variables. These variables for us will be terminal growth rate, WACC, market risk
premium and levered beta as they are the basic variables affecting the share price.

Sensitivity analysis will be done by showing the joint impact of two variables on the target
price: terminal growth rate and WACC. As it was already mentioned before the rate of return
and terminal growth rate are essential in forecasting any financial instrument, therefore we
chose these two indicators to do our sensitivity analysis.

Table 13: Sensitivity analysis changing WACC and terminal growth rate (Ryanair)
2.51% 2.61% 2.71% 2.81% 2.91% 3.01% 3.11% 3.21% 3.31% 3.41% 3.51%

9.70% 14.45 14.63 14.81 14.99 15.19 15.36 15.59 15.8 16.01 16.24 16.47

9.80% 14.23 14.40 14.57 14.75 14.94 15.13 15.33 15.53 15.74 15.95 16.18

9.90% 14.01 14.17 14.34 14.52 14.7 14.88 15.07 15.27 15.47 15.68 15.9

10.00% 13.80 13.96 14.12 14.29 14.47 14.64 14.83 15.02 15.21 15.42 15.62

10.10% 13.59 13.75 13.91 14.07 14.24 14.41 14.59 14.77 14.96 15.16 15.36

10.20% 13.39 13.54 13.69 13.85 14.02 14.17 14.36 14.54 14.72 14.91 15.1

10.30% 13.19 13.34 13.49 13.64 13.8 13.97 14.13 14.31 14.48 14.66 14.85

10.40% 13.00 13.14 13.29 13.44 13.59 13.75 13.91 14.08 14.25 14.43 14.61

10.50% 12.82 12.95 13.10 13.24 13.39 13.54 13.7 13.86 14.03 14.2 14.38

10.60% 12.63 12.77 12.91 13.05 13.19 13.34 13.49 13.65 13.81 13.98 14.15

10.70% 12.46 12.59 12.72 12.86 13.00 13.14 13.29 13.44 13.6 13.76 13.93
Source: Own calculations

These two variables are changed by 10 basis point downwards and upwards to see how they
will affect the price of the stock. From the whole enterprise value, almost 65% is the terminal
value, so it affects the final price a lot. Being the discount factor, WACC has its essential role
in target price valuation as well. Based on the sensitivity analysis it was possible to come up
with a result of target price changing between the range of 12.46 € and 16.47 € which is a
signal of target price potential to change 14% downside and 12% upside.

77
The same analysis were done for EasyJet to show the range of price fluctuations in case of
1% change in return on equity and terminal growth rate to both directions. The results are
illustrated in the table below.

Table 14: Sensitivity analysis changing r and terminal growth rate (EasyJet)
1.11% 1.21% 1.31% 1.41% 1.51% 1.61% 1.71% 1.81% 1.91% 2.01% 2.11%

7.66% 13.11 13.27 13.43 13.6 13.77 13.95 14.14 14.33 14.53 14.74 14.95

7.76% 12.91 13.07 13.22 13.39 13.56 13.73 13.91 14.09 14.29 14.48 14.69

7.86% 12.72 12.87 13.02 13.18 13.34 13.51 13.68 13.86 14.05 14.24 14.44

7.96% 12.54 12.68 12.83 12.98 13.14 13.3 13.47 13.64 13.82 14.007 14.19

8.06% 12.36 12.5 12.64 12.79 12.94 13.1 13.26 13.42 13.6 13.77 13.96

8.16% 12.19 12.32 12.46 12.6 12.75 12.90 13.06 13.22 13.38 13.55 13.73

8.26% 12.02 12.15 12.28 12.42 12.56 12.71 12.86 13.01 13.17 13.34 13.51

8.36% 11.89 11.98 12.11 12.24 12.38 12.52 12.67 12.82 12.97 13.013 13.3

8.46% 11.69 11.82 11.94 12.07 12.2 12.34 12.48 12.63 12.78 12.93 13.09

8.56% 11.54 11.66 11.78 11.9 12.03 12.17 12.3 12.44 12.59 12.74 12.89

8.66% 11.39 11.5 11.62 11.74 11.87 12.00 12.13 12.26 12.4 12.55 12.69

Source: Own calculations

The range in which the target price fluctuates while changing the cost of equity and terminal
growth rate is 11.39-14.35, or 16% upside and 12% downside potential change in current
price target.

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10. Investment Recommendations
In the current research paper, we came up with different target prices of Ryanair’s And
EasyJet’s stocks calculated with both relative and absolute valuation methods. These prices
apparently are not the same, so we need to decide which the final target price is based on our
calculations and assumptions for further recommendations whether to hold sell or buy each
of these stocks.

Table 15: Summary for all the target prices

Company Price Price Price with Average Market Delta Recommendation
with with EV/EBITDA calculated price
FCFF P/E Price
Ryanair 14.17 20.61 11.7 15.162 11.4 33% Buy
(€)

EasyJet 12.9 11.9 11.4 12.275 11.17 10% Hold

(£)

Source: Own results

The above table, illustrating all the results of prices calculated before, shows that Ryanair’s
stock prices are undervalued when calculated with FCFF and P/E, however, with
EV/EBITDA the target price is close to market price. The difference between these indicators
is reasonable, taking into consideration that EV/EBITDA doesn’t include capital
expenditures, that, however, are significant indicators in the airline industry. The next reason
explaining this difference is debt being fixed despite the stock price movement. So the net
debt of Ryanair forces EV/EBITDA to grow slower than the share price.

For EasyJet, all our results signal slightly undervaluation of the stock at the moment, even
after it has grown since September. As already mentioned before, this happened because of
possible Brexit delay news, which gives a boost to the price of the share. We assume that as
the Brexit will be close to happen, EasyJet’s price will again go down coming back to its
market value it had in September.

As there are a lot of uncertainties around these assumptions it is difficult to do a long term
forecast on the prices. What can be done is to give weights to the target prices determined
with different methods and to calculate their weighted average. We argued in this thesis that
discount cash flow models are more realistic for us, as they are based on company’s real

79
results so we would give them 50% weight and the other 50% will be divided between two
variable models. Eventually we got 15.16 Euro and 12.27 GBP as target prices of Ryanair
and EasyJet respectively, so the buy signal former and hold signal for letter is valid.

We would like to emphasize that recommendations were built on the assumption of soft and
orderly Brexit solution. As it was mentioned before the uncertainties around this event can
affect EasyJet considerably, so even with 10% upside potential we would avoid giving “buy”
recommendation.

To emphasize the credibility of the results acquired in this thesis, we decided to compare
them with the valuation done by J.P Morgan Cazenove on 04.02.2019 (Bloomberg, 2019).

The analysis done by the investment bank specialists are based on relative valuation method,
particularly, they have used EV/EBITDA and P/E ratios. For Ryanair they came up with a
target price of 14.25 Euro and 12.25 GBP for EasyJet.

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 CONCLUSION
The goal of this diploma thesis was to analyse the low-cost airline industry, with reference
to the selected companies. Our focus was the European market with two leading low-cost
airlines: Ryanair and EasyJet. We aimed to present a deep understanding of the internal,
external, and competitive environment of these companies, to analyse possible industry
sensitivities, and based on the acquired information, come up with stock valuation. Thus the
thesis is divided into three parts and each of those three parts represents a step for final goal
fulfilment. The first part introduces the theoretical background for the fundamental analysis.
It summarizes the main methods and provides all the terminology used in the calculations of
this paper. In the second part the overall industry, its main characteristics, and all the current
internal and external factors affecting companies are introduced. The third and crucial part
of this thesis is the valuation of low-cost carriers’ stocks using the fundamental approach.

Low-cost airlines’ phenomenon is hidden in lower fares of the tickets while excluding most
of the basic services offered on board by full-service carriers or including them in the
ancillary services. Thus, they are competitive in short-haul flights and have wider range of
passengers that can afford flying with them. The two budget airlines under the scope of our
research have been giants in the industry for more than 20 years. They have built a strong
business and have seen a sharp increase in stock prices during the post-crisis period with
reducing fuel prices. However, there are still several external factors these carriers are
sensitive to. The UK’s intention to leave EU creates the biggest uncertainty in the industry.
Jet fuel price fluctuations are another reason for stock price vulnerability. Moreover, recent
acquisition of Laudamotion by Ryanair creates concerns for possible variation from expected
profit. EasyJet’s profit can be lower than expected as a consequence of lower turnaround of
Tegel airport’s operations.

All factors mentioned above, were under consideration when evaluating the stock prices. We
used the discounted cash flow models for absolute valuation and P/E and EV/EBITDA
multiples as relative valuation methods. As Ryanair is unstable in its dividend paying policy,
it is inappropriate to use dividend discount model for it. Instead, we applied free cash flow
models. The predicted future cash flows were discounted by the weighted average cost of

81
capital, then the target stock price was found by doing the necessary adjustments. In contrast
to Ryanair, EasyJet was stable in its dividend paying policy that is why we have decided to
use the dividend discount model for its stock valuation. Future dividends were predicted
using the sustainable growth rate formula and then were discounted with cost of equity to
find the target price of the company. In order to support the results from absolute valuation,
we implemented the relative valuation multiples as P/E, EV/EBITDA and EVA. We took
into consideration the historical median of these ratios for each company as a benchmark and
applied them to estimate the target price based on the multiples. EVA indicator results from
2014-2018 were also presented to prove our assumptions about the future development of the
companies. In the end, we did sensitivity analyses to introduce the possible effect of
discounted factor and terminal growth rate on the final estimated price of the stock. Based on
our calculations we came up with recommendations “buy” for Ryanair’s stock and “hold” or
“neutral” for EasyJet’s stock.

In conclusion, operating in a highly competitive and under uncertain macroeconomic

environment these two companies still have potential to grow and thus are good options for
investing.

As this thesis was concentrated only in European market, it does not contain any analysis
outside of it. It would be interesting to analyse the American low cost carriers as well, and
do comparative analyses.

82
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 LIST OF ABBREVIATIONS

ASK Available seat kilometres

CAPM Capital asset pricing model
DCF Discounted Cash Flow
DDM Dividend discount model
EBIT Earnings Before Interest and Taxes
EBITDA Earnings before interest, taxes, depreciation
and amortization
EPS Earnings per share
EU European Union
EV Enterprise value
EVA Economic Value Added
FCFE Free Cash Flow to Equity
FCFF Free Cash Flow to Firm
GBP Great Britain pound
GDP Gross domestic product
IATA The International air transport association
IMF International Monetary Fund
LCC’s Low cost carriers
M Million
NOPAT Net operating profit after taxes
P/E Price to Equity ratio
ROE Return on equity
RPK Revenue passenger kilometres
SWA Southwest Airlines
UK United Kingdom
US United States
YTM Yield to Maturity

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 LIST OF FIGURES

Figure 1: Available Seat Kilometres for Four LLC’s

Figure 2: Revenue Passenger Kilometres for four LLC’s

Figure 3: Load Factor for Four LLC’s

Figure 4: Cost per Seat for Ryanair and EasyJet

Figure 5: Number of Passengers for Four LLC’s

Figure 6: Real GDP Growth Rate (European Union)

Figure 7: Inflation, Consumer Prices (annual %) in EU

Figure 8: Jet Fuel Monthly price -US dollars per Gallon

Figure 9: Broad Money (Euro Area)

Figure 10: Exchange Rate Euro per GBP

Figure 11: Annual Seats in Millions and Year-on-year Growth

Figure 12: Market Share of Low Cost Airlines and Others

Figure 13: Europe's Top 10 Low Cost Carriers (annual seat capacity in millions in 2018)

Figure 14: Europe's Top 10 Low Cost Carriers and Their Market Share

Figure 15: Ryanair Price Chart 2014-2019

Figure 16: Operating Costs of Ryanair in 2018

Figure 17: Operating Costs of EasyJet in 2018

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 LIST OF TABLES

Table 1: Overview of Valuation Methods

Table 2: Assumptions for Return on Equity Calculation

Table 3: WACC Calculations

Table 4: Historical Revenue Data and Average Results

Table 5: Dividends Paid by EasyJet (2013-2019)

Table 6: Cost of Equity Calculation for EasyJet

Table 7: Historical Revenue Data for EasyJet and Average Results

Table 8: Price Calculations Based on P/E (Ryanair)

Table 9: Price Calculations Based on P/E (EasyJet)

Table 10: Price Calculation Based on EV/EBITDA (Ryanair)

Table 11: Price Calculation Based on EV/EBITDA (EasyJet)

Table 12: EVA for Ryanair and EasyJet in 2014-2018

Table 13: Sensitivity Analysis Changing WACC and Terminal Growth Rate (Ryanair)

Table 14: Sensitivity Analysis Changing r and Terminal Growth Rate (EasyJet)

Table 15: Summary for All the Target Prices

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 APPENDIX
Absolute and relative valuation models of Ryanair and EasyJet are available in the
information system.

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