The price-to-earnings (PE) ratio, a key measure of valuation derived from historic annual earnings, is an especially notable instance of a lagging fundamental metric. Since February, airlines have seen trailing PE multiples drop from around 11 to less than 6, because prices have fallen by about 45% on average and reported earnings have not changed. Even forward PE ratios for airlines started at around 9 in February and dropped to about 6.5 in mid-April. Since then, forecasts of 2020 earnings have started to adjust downward, sending the forward PE ratio upward to end April at around 45.
So are airlines cheap, or are they expensive? If only answering that question were as simple as using a PE ratio. Over long periods of time, and applied to hundreds of stocks, building portfolios based on PE alone can add substantial value, but an emphasis must be placed on both the length of time and the breadth of application. In the case of airlines, those that survive the crisis without being nationalized or going bankrupt will undoubtedly be a great investment, but a lot more information is required to identify which airlines are most likely to make it.
This is where we start to peel back the onion of forecasting stock returns, going beyond PE ratios to consider other, more nuanced measures of valuation, and combining these with an assessment of company quality that includes balance sheet strength (e.g., solvency, operating efficiency, liquidity, leverage), sustainability, asset growth, and more. In the case of airlines, stronger companies will be more likely to survive the earnings downturn than those facing debt levels that will prove to be unsustainable in the near term. Unfortunately, getting accurate data on the state of a company’s balance sheet can be somewhat backward-looking, too.