Stock Analysis

Is Southwest Airlines Co. (NYSE:LUV) Trading At A 46% Discount?

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NYSE:LUV
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Key Insights

  • Southwest Airlines' estimated fair value is US$54.73 based on 2 Stage Free Cash Flow to Equity
  • Southwest Airlines is estimated to be 46% undervalued based on current share price of US$29.66
  • Analyst price target for LUV is US$42.57 which is 22% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Southwest Airlines Co. (NYSE:LUV) by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Southwest Airlines

The Method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) -US$453.0m US$559.3m US$945.6m US$676.0m US$1.64b US$2.00b US$2.33b US$2.61b US$2.85b US$3.05b
Growth Rate Estimate Source Analyst x3 Analyst x6 Analyst x5 Analyst x1 Analyst x1 Est @ 22.38% Est @ 16.30% Est @ 12.04% Est @ 9.06% Est @ 6.98%
Present Value ($, Millions) Discounted @ 8.2% -US$419 US$478 US$747 US$494 US$1.1k US$1.3k US$1.3k US$1.4k US$1.4k US$1.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$9.2b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.2%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$3.0b× (1 + 2.1%) ÷ (8.2%– 2.1%) = US$51b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$51b÷ ( 1 + 8.2%)10= US$23b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$33b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$29.7, the company appears quite undervalued at a 46% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
NYSE:LUV Discounted Cash Flow May 8th 2023

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Southwest Airlines as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.2%, which is based on a levered beta of 1.021. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Southwest Airlines

Strength
  • Earnings growth over the past year exceeded the industry.
  • Debt is not viewed as a risk.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Airlines market.
Opportunity
  • Annual earnings are forecast to grow faster than the American market.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Paying a dividend but company has no free cash flows.
  • Annual revenue is forecast to grow slower than the American market.

Moving On:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Southwest Airlines, we've put together three essential aspects you should further research:

  1. Risks: For instance, we've identified 3 warning signs for Southwest Airlines (1 is significant) you should be aware of.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for LUV's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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

Valuation is complex, but we're helping make it simple.

Find out whether Southwest Airlines is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.