Our Recommendation

BUY

Valuation & Security Analysis

British Airways

Price as of 31/03/05 :£2.63

Our Price : £2.99

Year 2005-2006

Headlines

Improvement in British Airways efficiency

Innovative “Manage My Booking” program

Reduction of assets

Aggressive cost savings policy

Tighter competition due to low costs companies: pressure on margins and low growth for revenues

Oil price skyrocketed: concerns about future oil and fuel costs

Uncertainty about the consequences of the Terminal 5 project

INDEX

Introduction

British Airways (BA) is one of the most significant airways companies globally, with the number of aircrafts in service at year end reaching 290. Passengers carried in 2003 – 2004 were 36,103, a fact that makes BA one of the leaders in the airways sector. Moreover, BA is a member of ‘One world’ alliance, which serves a network of some 600 airports worldwide in 135 countries; and was the only alliance to achieve a collective profit in 2004.

BA reports progress in all areas and at the same time BA reports a financial result that represents a significant improvement in the company’s fortune. In a more analytical view, the operating margin improved 1.5 points to 6.9%, approaching the 10% goal that the company has established. Profitability has improved across the network and in short haul the loss has narrowed from £300 million five years ago to £26 million. Furthermore, net debt has fallen to below £3 billion and it is at its lowest level since March 1993, still keeping strong cash position. Proceeding to the operating and the financial review we observe that group profits before tax for the year were £415 million, compared with a £230 million profit in the previous year. At a closer look, operating profit in the year was £540 million, which reflects improvements in turnover up to 3.3%.

As it is obvious, the operating expenses rose as well and reached £7,273 million with the fuel costs presenting the highest raise now expected to be about £400 million more in the coming year. Losses disposals of fixed assets and investments for the year were £26 million compared with losses of £46 million last year. In addition, net interest expense for the year was £157 million; £43 million lower than the previous year. As far as the working capital is concerned on March 31, 2005, net current liabilities were £136 million, down £95 million on last year. A rapid view in the share capital shows that the number of shares allots, called up and fully paid on March 31, 2005 was 1,082,903,000 and for the twelve month period profits attributable to shareholders were £251 million, equivalent to earning of 23.4 pence/share, compared with earnings of 12.1 pence/share last year.

BA operates in a challenging competitive environment and during the past years the sector faces a lot of problems. Yet BA succeeds to reach numbers, which place the company on the top of the aviation sector.

Industry analysis

An effective valuation of the present and future performances of a firm implies to take into account risks and opportunities related to its environment.

The purpose of our strategic analysis is thus to determine the overall attractiveness of the industry in which British Airways operates, as well as the sustainability of the competitive advantages of the company.

The market outlook

The airline industry is characterised by a very large number of players splitting between the low cost carriers and the mainline carriers. Concentration is not substantial for the moment as regulations concerning M&A are still weighting heavily and players prefer to implement strategic alliances through loyalty programs such as Skyteam or OneWorld or “code share agreement” which allow the companies to benefit from synergies. The overcapacity as well as the price pressure specific to the sector added to heavy investments and regulations are setting high barriers to entry and it is therefore quite hard for potential new entrants to launch a successful mainline carrier or a sustainable low cost carrier.

However, the deregulations which occurred in Europe and in the US has impacted positively the demand by lowering the fares and the market is now driven by a growing demand for business and leisure purposes. The industry is slowly recovering from the 9/11 and the SRAS and the recent enlargement of the EU should be a long term driver for demand inside the continent. This optimistic aspect can be observed in the growth of the Revenue Passenger Kilometres (RPK) which has increased by 9.4%¹ between 2004 and 2005 and is projected to increase by an average 5.5%² each year between 2005 and 2014.

However, the systematic risks such as epidemics or terrorist attacks as well as the increasing price of the fuel are of high concern for the industry and partly explain the underperformance of the sector with a $6 Bn global loss during 2004.

The challenges for the mainline industry

Mainline carriers are facing many challenges and difficulties. With the deregulations occurred in the United States and in Europe more recently, low cost carriers have flourished and even not always sustainable they have managed to attack severely the market share of the mainline carriers thanks to aggressive cut in prices. Studies held on the sector show that this phenomenon is not ready to regress but rather to increase, mostly in Europe where the low costs should benefit from the growing demand for short trips to visit the new European countries. As a matter of fact, in the US, mainline carriers have answer to this threat by reducing sharply their fares as well but in Europe, as the phenomenon is more recent, companies have not yet found a counter-attack. However, the main trend for mainline carriers is at cost savings in order to maintain their profit margins which are of about 2% for the whole industry even if this is not eased by the rising price in fuel.

The cost of the fuel appears as a major concern for the whole industry and particularly for the mainline carriers as the latter cannot impact easily the rise in their fares. On the contrary, low cost companies such as Easyjet, have been able to do so by increasing their fares without affecting their price discount position.

British Airways positioning

British Airways benefits from a strong branding of good customer service and reliability. With two thirds of its revenues realized between Europe and the Americas, BA is more than ever threaten by the low cost carriers which are concentrated in those areas. In addition, another critical challenge is raised by the potential merger of the US and EU markets which would give access to a “liberalised global market”. The overcapacity of the US market brings American companies to tap into the EU market, which is a main threat for B.A as the latter realises 75% of its EBIT in America and owns 25% of the market share in Europe.

For the moment, B.A has only privileged partnerships with Quantas and Iberia through joint business agreement but has not fully exploited its alliance with American Airlines to gain insight of the US market. A closer relationship with American Airlines could thus enable B.A to find a solution to this threat.

In a context of pressure on prices and intensive rivalry, the One World Alliance and all the technological innovations targeting the customers, such as the “manage my booking facility” or the “flat bed” are critical success factors to save costs and attract customer’s loyalty so as to success in this competitive industry. In addition, the move to the brand new Terminal 5 at Heathrow is a crucial competitive advantage and a challenge for BA. The transfer should concentrate all BA’s activities and provide customers a “unique experience” such as reducing their time of transit. On a long time basis, this should result in a growth in capacities and a reduction in operating expenses.

For 2004, employee and fuel expenses have accounted for about 40% of the total sales between 2004 and beginning of 2005. Through a very high and unpopular number of redundancies the company has achieved £450 millions of savings over 2003-2005 and is targeting a £300 million cost saving on employees by 2007.

This cost savings are made to counterbalance the rising price of the fuel which is projected to cost an extra £400 million next year to BA. Since 1999, oil barrel price increased from $10 to $ 65 today and is expected to increase even more in the future.

The company has thus benefited and will benefit from the hedging of its fuel costs for this year and for the coming year.

Concerning its financial structure, until now the company has used its free cash flows to reduce massively its debt without distributing any dividends and has chosen to pursue this trend for the next year despite a lower borrowing cost. For the moment the company does not need to renew its fleet as the average age of it is quite low (7 to 8 years in average over the last three years) but should consider increasing it with the launch of the Terminal 5 as the latter will increase capacities. The financial structure would therefore change at this stage.

In addition, the transition to the norms IFRS in July 2005 commits BA to recognise its pensions deficit of £1.4 billions in the balance sheet which will impact negatively the reserves and the distributable reserves in particular, which should impact the share price.

Now that we have defined the challenges to which the industry and British Airways in particular are facing, we can implement a valuation of the company based on forecasts linked to different scenarios.

Accounting analysis

The financial statements of British Airways for the year 2005 have been issued according to the UK GAAP. From this point, the statements will be based on IFRS, a fact that will cause an important change on the statements of the company. This change will appear mostly on liabilities, due to pension obligations. The basic categories of the financial statements are the following:

Revenues

The revenues of the company are separated in traffic revenues (90% of total revenues) and in other revenues related to flight services (10% of total revenues). There are no other revenues appearing in the financial statements, so the total revenues of the company account to normal operation.

Expenses

Cost of sales and administration expenses are both directly related to normal operation. Net financial expenses are mostly interest on financial obligations due to finance on equipment. The rest operating expenses are insignificant.

Assets

All assets, apart from the short-term investments, are accounted as operating assets. The most important of these are: properties, plants, equipment, landing rights, goodwill, current operating assets as cash, inventories etc. The effects on the company’s assets under the IFRS will be unimportant and most of them will be valued as they are valued in the UK GAAP. The only change on the assets will be based on IFRS 21. IFRS 21 imposes changes in ‘Foreign Exchange Rates’ and the result will be the increase of net assets approximately to £162m for the year 2005.

Liabilities

A big part of the company’s liabilities are ‘operating liabilities’ and they mostly consist of deferred income taxes and current liabilities, i.e. creditors, accounts payable etc. IFRS will have a great impact on liabilities. According to ‘Standard IAS 19’, ‘Employee Benefits’ liabilities are understated in UK GAAP as an amount of £1.2b. This amount will be recognised in the financial statements for the year 2006.

To summarise, the financial statements of BA are quite straightforward. There are no significant assets or revenues related to business besides the company’s core occupation, and therefore these are accounted as operating revenues/assets. The introduction of IFRS from next year will influence mostly the ‘Reserves in Owners Equity’ and the ‘Liabilities’. ‘Operating income’ and ‘cash flow’ will remain almost the same.

Financial Analysis

Assumptions

The “Share of Operating Income from Associates” in the Income Statement is considered as part of operating profits.

We consider Assets and Comprehensive earnings cleaned of Minority Interest

Return of Net Asset

Firstly, we observe that the profit margin goes up after 2002, thus the firm’s ability to keep sales as operating profits becomes better. This evolution arises due to the stabilization of sales after 2002 and due to the diminution of the relative cost of sales. This highlights the efforts of cost savings and the resulted efficiency of the firm. The 2001 events triggered the cost savings policy at British Airways, as well as the tightest competition from low cost companies.

Secondly, the asset turnover is getting better after 2002. Once again, this shows the ability of British Airways to improve the revenues generated from its operating assets. Actually, BA has managed to keep its revenues while reducing its fleet. Nevertheless, we should also consider the large participation of the ₤1 billon deferred tax that tremendously reduces the net operating assets.

Consequently, the RNOA is going up after 2002 and reaches the level of 1999 in 2005.

Return on Common Equity

Firstly, the net borrowing cost is diminishing over years (except in 2001). This is a result of the growing tax effect and of the quicker decrease of interest expenses in respect to debt.

Secondly, the financial leverage is fluctuating between 1.35 and 3.19. The sharp increase in 2003 is a result of the $1 billion decrease in equity, combined with the ₤1 billion increase in deferred tax. However, the trend is a decrease of the financial leverage, as short-term investments are increasing and capital leases are decreasing over the years.

Consequently, the ROCE is getting higher after 2002, driven by the growing RNOA and the growth of the efficiency in the funding structure.

By breaking down the ROCE in return on sales, asset turnover and leverage, we can once again observe the higher efficiency of BA to extract profits from sales and to produce revenues from assets and the contribution of the capital structure.

Working Capital

Apart from 2002, the net working capital is growing. As it is obvious in the following graph the current assets are going up, driven by stronger short-term investments, while current liabilities are decreasing slightly. The increase in short-term investments is not really comprehensible and, even if it reduces the liquidity risk for the firms, British Airways should reduce them. Thus BA improves its profit from a higher leverage, (which creates value now; cf. ROCE) and decreases its net working capital. However, the decrease in accounts payable that drives the decrease of current liabilities shows that BA must pay its providers quicker during 2005. If this may be the consequence of a more competitive environment, it is still important to raise a flag.

When comparing to sales, we really see the drop in payables and the recent slight increase in receivables. The increase in net working capital is lowering the cash flows of British Airways and could damage its reinvestment policy.

Capital Expenditure

The CAPEX is going down sharply after 2002. This is mainly due to the fleet reduction decided by the management.

Dividend

British Airways has not paid any dividend since 2003. The management has engaged the firm in a policy of early repayment of debt and leases. The goal of this policy is to clean the balance sheet and become owner of the planes. The remaining cash flows are invested in short-term instruments and will be used to repay debts and to pay the costs of planes deliveries.

Conclusion on the financial analysis

After the 2001 events and the tightening of the industry competition, British Airways has tremendously improved its efficiency in terms of profits generated from assets and revenues, especially by cutting costs. At the same time, the cost of debt has decreased, resulting in a positive contribution of leverage to the return on equity. Consequently, the return on common equity has increased, reaching 13.17% in year 2005.

The net working capital of British Airways is increasing regularly, and could potentially damage the firm’s cash flows in the future. BA is engaged in a policy of early repayment of debt by using the cash flows generated by the operating activities. No dividend has been paid since 2003 and the CEO has announced that they should not pay dividend in 2006. Consequently, the paradox that leverage is now creating value for the firm and the debt is being quickly reimbursed could be problematic for the company’s performance. Moreover, even though the fleet is relatively young, the non-investment policy could limit the growth opportunity, once the increase in efficiency (return on assets) will reach a limit.

Assumptions made to build the model³

We are first going to explain how our model works and then what assumptions we made in order to make our model vary.

The time horizon we have chosen for the forecasts is 5 years, that is to say 2010. As we gathered accurate information for the following three years only, we decided to limit the forecast horizon and to assume that British Airways activities will grow at a constant pace after 2008.

Calculation of the revenues

We compute the total revenues forecasted as the ratio between the traffic revenue from RPK and the percentage of the traffic revenue from RPK over the total revenues obtained from the income statement.

We first forecasted the evolution of the number of planes. From this, we computed the RPK as the average number of planes times the ASK and the load factor, which are given factors.

In order to obtain the total revenue, we then need to compute the part of the total revenues from the income statement that is dedicated to the traffic revenue from RPK and discount our computed traffic revenue from RPK by this ratio.

The assumptions set for the calculation of each component are as follow:

In order to maintain an average age of the fleet of 7 to 9 years, we assume that the fleet will increase of one aircraft each year from 2008 except in 2007 and 2008 as the selling of the five British Aerospace 146 between 2005 and 2006 and the delivery of 7 new Airbus should lower the average age of the fleet. The company should not therefore need to buy any plane in 2007. In 2008 however, in order to benefit from the increase in capacities brought by the move to the Terminal 5 and the mixed-mode operations, we assume that the net number of aircraft will increase of 5. We thus obtain an average number of aircrafts of 293.5.

We assume that the load factor should increase of 0.5% each year over 5 years as a result of the “manage my booking” facility.

We consider that the ratio of traffic revenue from RPK over the total revenues will remain the same as the one in 2005, namely 83.13% as we do not find any trend.

We assume that the ASK (i.e the capacity ) per aircraft will grow by 5% for the next year but then the growth will decrease of 1% each year due to a high competition and the difficulty to keep marginal increase constant. The RPK will decrease by 3% the next year due to high pressure on prices with a smooth growth of decrease of 0.6% following a straight line so as to have 0% at the end of our explicit forecasting horizon.

Calculation of the cost of sales

The cost of sales is based essentially on three main items: the total operating expenditure, the depreciation and the fuel cost. The employee costs (as part of the total operating expenditure) and the fuel cost are likely to be very volatile in the next years as seen in the strategic analysis (even though there is a hedging policy for the fuel costs). Therefore, we make the assumption that the total operating expenditure over the sales will remain the same as in 2005 (68.49%) regardless of cost savings and fuel costs which are to be deducted. Cost savings are then assumed to be of 3% over 2 years, reflecting savings on employee costs, and of 1% thereafter, traducing the trend of the mainline companies.

For the estimation of the fuel cost, we first estimated the number of barrel per aircraft and conserved the 2005 figure as an estimate for the future years. However, as we know that the fuel and oil should cost to BA an extra 400 millions in 2006 as a result of the high volatility of the prices of those commodities, we assumed that given a constant hedging efficiency the price of the barrel would increase by 36.17% in 2006, then decrease by 5% the year after to adjust for 2006 high volatility, and finally keep the increase at 2% yearly

The depreciation is computed as a percentage of the forecasted NOA. The weight is given by the ratio of the depreciation over the NOA in 2005, that is to say 10.51%.

The operating costs

The selling and administrative costs are linked to the total revenues with a weight of 1.57%, as of 2005, and the goodwill amortization is defined to remain at the same level as of 2005, that is to say £5000 per year.

As the company has used all its tax credits, it is due to pay tax for the coming year at 35%.

We consider that the “Share of Operating Income from Associates” will be linked to the sales with a weight of 0.20% each year, as of 2005.

The asset turnover

It is defined as the revenues forecasted over the asset turnover. Given the fact that BA is improving its efficiency as said in the financial analysis, we will make the asset turnover grow by 0.20 during next year and then stabilize at 1.42, when it will reach the average figure of the industry.

The capital expenditure

Our calculation of the CAPEX is based on 3 items: the expected costs of purchasing new aircrafts, the landing rights and the investment made for the move to the Terminal 5.

We assumed that the average cost of a plane will be of £36,054.16 that is to say the average of the transportation cost over the number of aircrafts each year. As aircrafts are accounted at historical cost on the balance sheet we adjusted this price by the inflation rate which we set at 10% (according to historical data). We then found that the average over two years of the estimated cost of the purchase of aircraft was accounting for 89.01% of the CAPEX and that we can thus keep this number to forecast the CAPEX relative to the purchase of aircrafts over the years.

The landing rights are estimated to be equal to the average over 4 years, which is of 22.50.

Concerning the CAPEX related to the move to the Terminal 5, as we do not have much information about it, we assume that the remaining cost will be of 50 millions over 3 years.

The deferred taxes

Given that there is no trend for the change in deferred income and taxes, we will assume that it is equal to the deferred tax as of 2005 and that it will then increase at the same pace as for the revenues.

Forecasting beyond 2010

Concerning the growth to perpetuity for free cash flows and earnings, we have decided to be conservative. Indeed, even though we know that analysts are forecasting a 1%-2% growth for the sector and an inflation rate around 2%, we have decided to use a 0.4% growth rate for BA FCF and earnings. Actually, we think that the tighter competition in the sector will reduce the growth figure for BA comparing to the economy; we think that if we assume that BA will manage to stay a top Airlines company, it will have to cut on its margins. As we defined this number on a subjective basis, we will use a 0.2% – 0.6% range.

Calculation of the WACC

Thanks to data found on Bloomberg we manage to obtain the Beta, the risk free rate and the market risk premium. From then on, we can compute the cost of equity of the firm through the CAPM model. The cost of debt is obtained by adding a 1% spread (due to credit rating under the investment grade) to the company forecasted cost of debt of 5% in 2005⁴. As the company has kept reimbursing their debts, we assume that the target finance structure of the company by 2010 is 60% on equity and 40% on debt. The tax is set at 21.4% as the average over 6 years of the tax effect over the net financing expenses.

We thus obtain a WACC of 9.1% and a cost of equity of 12%.

Forecast

Revenues

The revenue forecasted for British Airways grows on average of 2.50% each year until 2009 as the result of the higher efficiency of the firm during the past years and the growing number of aircrafts in its fleet. Between 2009 and 2011, the revenue’s growth is stabilizing itself as it has reached equilibrium between optimum efficiency and price pressure.

On this graph, we clearly see the pace slowing down in 2011, because the firm is reaching its optimum revenue.

Cost of Sales

Costs of sales are mainly linked to revenues, except for depreciation and fuel. Cost savings allow the growth of BA’s costs to slow down for years 2006 and 2007, since the firm is targeting £300m of cost savings during those two years as a result of its aggressive policy of reduction of its workforce. Consequently, the increase in costs is sharper for the following years. Depreciation decreases in 2006, as BA reduces its assets and takes advantage from a better asset turnover. We then link the pace of the depreciation to the one of the revenues which explains the slightly increasing pace of it. Concerning fuel costs, the fast increase of oil price on markets will have a direct impact in 2006, and should cost an extra £400m compared to 2005 figure. As 2006 will probably be followed by a quieter year for oil prices, our assumptions imply a decrease in fuel costs in 2007 of 5%, and a reasonable 2% increase for the following years.

This graph shows that costs increase in 2006, due to high oil prices, and in 2008, as cost savings go down from 3% to 1%.

Gross Margin

Gross margin as a percentage of revenues decreases in 2006, as a result of high oil prices. However, the margin percentage after 2007 is reaching the 2005 level, sustained by the increase in efficiency and the aggressive cost savings policy. During the 2008 – 2011 period, the gross margin decreases at a slow pace but, once again due to high competition from low cost companies, reaching an equilibrium at around 7%.

This graph shows that the gross margin stabilizes after 2008.

Operating Income

Administrative expenses and dividends from associates are linked to revenues while goodwill amortization is kept constant over years and tax is charged at 35% of operating income. Consequently, the operating income after tax evolution over years is comparable to that of gross margin.

Change in Net Working Capital

Having forecasted the revenues, we have assumed that British Airways asset turnover will reach the average level of the sector of 1.42 in 2006. We can thus forecast the net operating assets. The sharp decrease of NOA in 2006 is the consequence of both the policy of assets reduction of the company and the improvement of its general efficiency. The growth of NOA is then comparable to that of revenues. We made the strong assumption that the net working capital will be 4% of revenues, even though this indicator has been very volatile in the past. Then, the NWC evolution over years has the same shape as revenues.

Capital Expenditure

The determination of capital expenditure has been explained in the previous section. The investments are very low in years 2006 and 2007, as British Airways reduces its assets. Then, the CAPEX turns around £300m. However, it is hard to know the real impact of Terminal 5 in terms of investment and whether BA will boost its investment policy in the future. The choice of determining stable CAPEX is consistent since we do not think BA can handle projects with high abnormal return in the near future.

This graph shows the stable growth of CAPEX starting from 2009.

Deferred Income and Tax

The change in deferred income and tax increases at the revenue pace, as we did not find any trend.

Balance Sheet

Having linked the NOA to the revenues, the forecast of the balance sheet is straight forward. As BA has been decreasing its debt ratio and has announced its desire to keep on doing so, we have targeted a 40% debt ratio for 2010. We then have chosen to decrease this ratio following a straight line. The shareholders’ equity is then determined according to the following formula:

NOA = NFO + Shareholders’ Equity

We then determine the debt repayment (or issuance) as the difference between the NFO amounts from one year to another.

The liability part of the balance sheet is growing at the revenue pace during the 2005 – 2010 periods, as we fixed the asset turnover to the industry average. We see that the proportion of equity is growing at a constant rate until it reaches the targeted 60% of the financing structure at the end of 2009.

Valuation

Discounted Free Cash Flows to Bondholders and Equityholders

Given our assumptions, we find a price of 3.50£ for BA share price by discounting the free cash flows to bondholders and equity holders. The free cash flows of BA decrease sharply after 2008, as the company reinvests in aircrafts, having completed its asset reduction policy. Once again, we assume that cash flows grow at a slow pace, as we use a 0.40% perpetuity growth reflecting price pressure on the industry and fierce competition from low costs carriers; the only way to keep its market share is to cut on its margin.

This table is a sensibility analysis of BA’s share price using different WACC and growth values around our assumptions. Later on, we will consider the prices obtained using a 9% – 10% range for the WACC, and a 0.2% – 0.6% range for the growth. A move of +1% in the WACC decreases the share price by 0.61£, and a move of +0.2% in the growth increases the price by 0.09£.

Discounted Free Cash Flows to Equity holders

Having determined debt payments and issuances (cf. previous part), and considering that BA will manage to keep its NFE at the low rate of 2.06%, we can easily forecast the free cash flows to equity holders. The last line of the table is the cumulative cash obtained by BA, starting from 2005 cash balance; this line will be useful for the abnormal earnings approach.

By discounting the free cash flows to equity holders, we find a price of 3.01£. We use the same growth rate for as previously, and an expected return on equity of 12.00%.

The sensibility analysis shows that this approach is more accurate than the previous one. Considering the prices obtained using a 0.20% – 0.60% range for the growth and a 11% – 12% range for the expected return on equity, we see that a 1% increase in the expected ROE results in a 0.30£ decrease in the share price, and that a 0.20% increase in the growth rate implies 0.03£ increase in the share price.

Abnormal Earnings

By discounting the abnormal earnings, we find a price of 2.78£. We assume that the company reinvests all its cash flows at its expected return on equity, that is to say 12.00%.

This approach is more accurate, as the range of prices is tight. Assuming a 0.20% – 0.60% growth range and a 11.00% – 12.00% expected ROE range, the price will fall by 0.20£ if the expected ROE increases by 1%, and will increase by 0.01£ if the growth rate goes up by 0.20%.

Price Earning Ratio

We first calculate the average price earning ratio for the sector by gathering information about direct competitors in Europe. The average ratio is 12.68. Using 2006 forecasted earnings, we get a price of 2.78£ for BA shares. We will consider an 11 – 14 PER range in the following part of this case

Comparison of different valuation methods

Assumptions:

For the FCF EV approach, we will assume a growth range of 0,2% – 0,6% and a WACC range of 9% – 10%

For FCF Equity Approach, we will assume a growth range of 0.2% – 0.6% and an Expected Return range of 11% – 12%

For Abnormal Earnings Approach, we will assume a growth range of 0.2% – 0.6% and an Expected Return range of 11% – 12%

For the PER Approach, we will assume a PER range of 11 – 14

We then get the following chart, showing the price ranges according to different methods:

This chart allows us to find a price satisfying the different methods used in this case. By taking the average between the highest low and the lowest high of the ranges, we find a price of 2.99£.

Conclusion

The value of British Airways stock is hard to determine given the numerous challenges that the firm will have to face in the future.

Firstly, the highly volatile oil price in 2005 is a potential source of bias for the valuation as they are not fully predictable and it depends on the company’s hedging policy.

Secondly, the sector is changing at a fast pace with the surge of low costs companies such as Easyjet and Ryanair. Thirdly, British Airways is running an aggressive cost savings and asset reduction program that is hard to forecast. Last but not least, the impact of British Airways Terminal 5 Project on the stock value is almost unpredictable, given the lack of information about it.

Even though we think that our assumptions are comprehensive, we have decided to undertake different methods and especially one that is not based on our assumptions (PER), to reduce the error risk.

Finally, we find a price of 2.99£ for the stock, which is above its quote on the markets on March 31, 2005. We thus strongly recommend investors to buy this stock, as the market price bears a 15% discount comparing to our price.