Ryanair: DCF Model Suggests 41% Upside To Current Market Price

Summary

• Ryanair operates ultra-low-cost routes throughout eastern and western Europe.
• Its recent acquisitions demonstrate it is consolidating its position in established territories, and expanding its vision to new markets.
• Strong traffic growth (11%) in Q1 FY20 shows a continuing consumer trend toward low-cost air travel.
• Using a calculated discount rate of approximately 6%, I value Ryanair’s shares at €12.53 and rate it as a buy.
• Issues such as the grounding of the new 737 Max aircraft, a "no-deal Brexit" and security concerns suggest a vigilant investment approach should be advised.

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Investment Thesis:

The objective of this article is to provide the reader with a comprehensive valuation of Ryanair (NASDAQ:RYAAY)(LON:RYA) using a Discounted Cash Flow (DCF) Model, and by making assumptions about its future cash flows and potential for growth. Based on the results of my DCF and evaluation of other factors discussed throughout this article, I value Ryanair's shares at €12.53 and rate it as a buy.

Some of the key assumptions made within the DCF model include an average growth rate for the forecast period, maintaining an average operating margin, and the average effective tax rate Ryanair can expect to pay.

Key Challenges/Opportunities:

737 Max:

Ryanair's investment in the "game changer" 737 Max is expected to bring about significant cost savings for the airline, as each 737 Max has 4% greater capacity, 16% less fuel consumption and 40% lower noise emissions. According to the Q1 FY20 results published recently by Ryanair, the board believe that these aircraft will "transform [Ryanair's] costs and business." However, due to the tragedies aboard the Lion Air and Ethiopian Airlines flights in October 2018 and March 2019 respectively, an international grounding of the 737 Max has been put in place. As a result, Ryanair has been forced to delay its anticipated receipt of its first 5 737 Max aircraft to "January 2020 at the earliest," and reduce its expected fleet of 737 Max aircraft from 58 to 30 by summer 2020 - resulting in the predicted cost savings being delayed until FY21. Yet, this relies upon the 737 Max being cleared for flight by the FAA and its counterparts around the world, and despite test flights of the updated 737 Max being completed successfully, it could be some time before regulators clear the aircraft for passenger service.

Excess Capacity in Germany:

In one of Ryanair's strongest markets, Germany, airlines Lufthansa and AirBerlin merged last year - which has resulted in a large amount of excess capacity within Germany due to the two airlines no longer competing, and acting as a single business. In order to compensate for this overcapacity, Lufthansa has been selling seats below cost price within Germany - resulting in their fares being lower than Ryanair's in many cases. The effect of this has been a fall in revenues in Germany in Q1 FY20, and it is something that the board of Ryanair expect to continue throughout H1 FY20, and also potentially into the second half of FY20. However, I believe that the effects of this will only be temporary - as clearly, it is unsustainable for Lufthansa to sell seats below cost price - and the airline will reduce capacity in order to return to a more optimal price point. The key risk for Ryanair is that their strong position within the German market may be undermined in the short term by the lower fares that Lufthansa is able to offer, but provided Ryanair can cut fares to remain relatively competitive with Lufthansa - I believe the issue is unlikely to persist into FY21.

Failure of other airlines:

In recent years several airlines have collapsed, including: FlyBMI (February 2019), Monarch Airlines (October 2017) and the sale of FlyBe (January 2019) - and this can be viewed as both a challenge, and an opportunity for Ryanair. Generally, the airlines that have failed of late have had highly leveraged capital structures and been relatively small in size - two traits which are fortunately not applicable to Ryanair. However, the failure of smaller airlines could be indicative of a consolidation of the low-cost air travel industry into a smaller number of larger businesses - suggesting that Ryanair should ensure its business is not eventually absorbed by a larger budget airline carrier. Despite this risk, there is the opportunity that failures of other airlines inevitably present: lower supply within the market. If Ryanair can acquire the rights to the profitable routes that failed airlines leave behind, then this could benefit the growth of its EU business significantly.

Brexit and access to the UK market:

There is also the issue that Brexit presents for Ryanair - since a large number of routes that it operates fly to or from destinations within the UK, any delay in getting regulatory approval to fly within the UK could seriously harm Ryanair's business. Since the UK will leave the EU on Oct. 31st "with or without a deal," this could result in a period whereby regulations are simply unprepared to accommodate this change. Moreover, consumer confidence within the UK has been damaged by the uncertainty surrounding Brexit; and this has been shown in Ryanair's Q1 FY20 results. A muted level of general consumer confidence throughout the economy is likely to continue until some degree of certainty surrounding Brexit has been established, but it is likely that this will not be confirmed until after Ryanair publish their H1 FY20 results. Of course, this issue potentially affects all airlines that fly in and out of the UK, however it has been raised as a key concern in several of Ryanair's previous annual reports, therefore it is worth noting as a key point during the valuation of the company's shares.

Finding a Cost of Capital:

In order to find the cost of capital to appropriately discount Ryanair's future unlevered free cash flows, both the cost of debt and cost of equity need to be calculated. I have used the market debt-to-equity ratio which excludes operating leases, as I feel that the information publicly available regarding the operating leases Ryanair is currently party to, and is planning to enter into in the future, is insufficient, and would therefore introduce an unacceptable level of error into the calculation. If any readers feel that this treatment is incorrect, or that there is a method of including operating leases as a component of debt that can be extrapolated over the forecast period without such a high level of inaccuracy, please do let me know.

Cost of Debt:

There are 3 steps to finding the cost of debt for Ryanair; the risk free rate for the valuation currency (Euros), the country default spread (based on the countries in which Ryanair operate), and lastly a company specific default spread for Ryanair.

Risk free rate:

The risk free rate applicable to Ryanair is the risk free rate for Euros, which, using the lowest interest 10-year Euro Bond, which has an interest rate of -0.5% at the time of writing.

Country-specific default spread:

For the country default spread, I have used Damodaran's table of country-specific default spreads for each country that Ryanair operates in - in order to reflect the level of risk that lenders would be expect to face as a result of Ryanair conducting operations in each country. The idea that some countries are riskier to operate in, as a result of economic, political or other factors, results in creditors demanding a higher level of return to compensate for the additional risk - and this needs to be reflected in the cost of debt calculation.

Ryanair splits its revenue out by individual country, therefore the risk premiums for each applicable country can be weighted against the appropriate amount of revenue generated in that country (please see below.)

Source: Author, based on Ryanair's Financial Statements

However, as you can see from the above, the revenue is only broken down into the top 5 countries and then "Other European Countries," which means that we need a way of calculating the default spread for the other European countries (i.e., the figure above that has been highlighted blue.) The best way in which to do this, in my opinion, was to compile a list of airports from which Ryanair operated, exclude all the countries that have already been included above, and calculate how many bases lie in each country (please see below). This can then be used to weight the default spreads for each country, and then come up with a value for the default spread for "Other European Countries."

Source: Author, based on Ryanair's Financial Statements

This analysis assumes that there is a direct relationship between the number of airports operated out of and the amount of revenue generated, which is potentially unlikely in practice due to airports being of different sizes and flying multiple routes. However, in the absence of more information being publicly available, I concluded this was the best way to apportion the default spread for "Other European Countries."

As a further point, the risk of Ryanair operating in riskier countries could be reduced somewhat by the fact that an airline business, by nature, is able to direct its fleet to fly different routes if there is instability in a certain country. This would, of course, depend on the circumstances of the instability, but since there is no real quantifiable way to measure this we shall assume that Ryanair does not change routes if there is instability in a certain country (and also to remain conservative.)

Company-specific default spread:

The third and final aspect of the calculation is to compute a company-specific default spread for Ryanair - and since, fortunately, both Moody's and S&P have provided a credit rating for Ryanair, this step is relatively uncomplicated. Ryanair has a rating of BBB+, and when this is used in conjunction with the approximate debt spread for companies with turnover >$5bn, we find that the appropriate figure for a company with a BBB+ credit rating is a debt spread of 2.00%.

When the risk free rate (-0.5%), the country risk premium (1.44%) and the company specific debt spread (2.00%) are put together, we find that Ryanair's pre-tax cost of debt is 2.94%.

Source: Author, based on Ryanair's Financial Statements

Cost of Equity:

The method for calculating the cost of equity for Ryanair is similar to that of calculating the cost of debt: the risk free rate, a beta to reflect the leverage of the company versus the industry that it is in, and lastly a cost of equity that reflects the economic, political and other risks associated with conducting operations in each of the countries that Ryanair does business in.

Risk free rate:

The risk free rate is very simple; again just the interest rate for a German 10 year bond (-0.5%), as this best reflects the risk free rate of the Euro.

Beta:

Whilst trying to formulate a Beta for Ryanair, I was consciously aware that any Beta that I found online would likely be a regression Beta and therefore contain a large amount of statistical error - and this was shown to be true as I found several supposedly identical Betas online with completely different values. Despite attempting to calculate a bottom-up Beta using methodology I found online, I was unable to successfully calculate a reasonable value (if any readers have any guidance on the best way in which I could go about doing this please do let me know in the comments!) Therefore, I have used the FT 1 year trailing Beta (1.066 - correct as of 10/08/2019) for the remainder of this valuation. Readers are welcome to use their own value for Beta if they wish to re-perform the valuation with different assumptions - however I felt that the 1 year trailing Beta would be most appropriate for this calculation.

Equity Risk Premium:

In order to calculate the equity risk premium for Ryanair, I will use the same methodology as used above to calculate the country-specific default spread, but using equity risk premiums instead of default spreads. The equity risk premium measures the excess returns from a market portfolio over a risk free rate appropriate for that country or currency. Please see below for how the ERP has been apportioned by country.

Source: Author, based on Ryanair's Financial Statements

Taking a weighted average of the ERPs (apportioned in the same way as default spreads were in the previous section; please see below for how the figure highlighted in blue was calculated) we arrive at the figure of 7.72% for the ERP.

Source: Author, based on Ryanair's Financial Statements

Combining these 3 figures, we would arrive at a cost of equity of 7.73% for Ryanair; however this excludes the risk from purchasing aviation fuel (a significant component of Ryanair's costs) from the calculation. It is necessary to include this risk as there are no easily accessible alternatives for aviation fuel, and the vast majority of oil comes from the Middle East, therefore it may be prudent to include the risk in the calculation of the cost of capital. Since fuel expenses accounted for 31.5% of Ryanair's operating profit, the Middle East ERP of 9.58% has been included in the final cost of equity calculation (see below - please note the figure highlighted green has been taken directly from the table above.)

Source: Author, based on Ryanair's Financial Statements

Source: Author, based on Ryanair's Financial Statements

After including the fuel weighting into the ERP calculation, I calculate that the appropriate ERP for Ryanair is 8.17%. When this is combined with the risk free rate and the Beta (see above) we arrive at 8.20% as the final figure for the cost of equity for Ryanair. Please note that this is at a tax rate of 20% (please see the Tax Rate section below for explanation as to why I consider this treatment to be appropriate going forward.) Furthermore, the cost of equity may not be consistent between years due to the levered Beta changing due to variations in the effective tax rate, which would hence change the positive/negative effects of the tax shield. For example, if the effective tax rate rose, then the cost of equity would be lower, since there would be a greater tax shield effect due to the amount of interest paid on debt.

Cost of Capital:

When we bring the above analysis together (please see the table below) we arrive at a cost of capital of 6.23% at a marginal tax rate of 20%. However, if the marginal rate of tax was set at the average for the previous 5 years (see above) at 10.12%, then the cost of capital rises to 6.33% - demonstrating the effects of the tax shield on the overriding cost of capital. Yet, for the reasons discussed below, I believe that 20% is a more appropriate figure to use for the marginal rate of tax in a long term forecast.

Source: Author, based on Ryanair's Financial Statements

Below, I will use this newly-calculated cost of capital to discount projected cash flows back to their NPV.

Estimating Future Growth:

There are several factors that affect estimates of the expected growth of Ryanair in the next 6 financial years (the forecast period). These include the risks mentioned in the openings of this article, but also the strengths and opportunities that Ryanair has - i.e. having the lowest unit costs of any budget airline and a strong brand image throughout Europe.

Critically analyzing Ryanair's FY20 forecast as a starting point, the company estimates that fare prices will grow in the region of "-2% to 1%" in H1 FY20 - but is unable to provide a forecast for H2 FY20 due to Brexit and several other significant issues arising during that half of the year. In conjunction with the 737 Max delivery delay (discussed earlier) Ryanair estimate that any meaningful cost savings from the new aircraft will not be delivered until 2021.

As a result of the issues discussed earlier in the article and above, I believe that FY20 revenue will remain roughly flat, due to the concerns surrounding Brexit and the delays with the 737 Max. To err on the conservative side, I have estimated that FY20 revenue will fall by 1% - mainly due to the significant uncertainty surrounding Brexit (under 100 days until the UK leaves the EU regardless of whether or not a deal has been struck.) Past FY20, and looking further along the forecast period, I believe that an average growth rate (i.e. for FY21 through to FY26) of 2% is a reasonable estimate for the period. Despite Ryanair averaging strong growth rates of 8% in both FY18 and FY19, given the future issues it faces, I believe that a lower average growth rate over the next 6 years is more appropriate.

Estimating Effective Future Tax Rates:

Below I have created a graph to illustrate the difference in effective tax rates between Ryanair and its nearest competitor (EasyJet) - and clearly Ryanair is able to benefit from lower effective rates of tax (an average of 10.12% during the period vs 18.80% for EasyJet.) However, this raises the question: for how long can this continue?

Source: Author, based on Ryanair & EasyJet's Financial Statements

Rising future effective rates of tax are an issue that has been raised in each of Ryanair's annual reports for the preceding 5 years, due to the scrutiny that the Irish government (where Ryanair pays the majority of its tax) has come under by the EU for offering multinationals favourable rates of tax. Notably, in 2016 the EC (European Commission) ruled that Ireland had given Apple unfair tax breaks, resulting in a €14.3bn bill due for back taxes and interest - perhaps indicative of a shift in attitudes regarding favorable tax regimes. Assuming that this is the case, and in the interest of remaining conservative in my estimates, I have used a 20% tax rate from FY20 onwards, as although changes are unlikely to occur in the immediate term, it is exceedingly likely that the Irish tax rate will rise in years to come. Please see the table below which demonstrates the effect of using a 20% tax rate.

Source: Author, based on Ryanair's Financial Statements

Estimating Capex Investment needs:

In order to estimate the level at which Ryanair will require working capital to finance future capital expenditure, I have used an average of the preceding 3 years to calculate an expected percentage of operating profit that is reinvested in capital expenditure. In the previous 3 years the percentage of operating profit that was used for capex was 94.5%, 88.2% and 152.3%, giving an average of 111.7%, which I have used as the basis for estimating the proportion of operating profit that will be used for capex in the future. Long term, this is unlikely to remain constant (as eventually shareholders will demand a return in the form of either dividends or capital gain, restricting the amount of operating profit that can be reinvested). Yet, in the short term, this is likely to be a reasonable assumption due to the orders for 737 Max that Ryanair has placed and expansion into new markets such as Poland (acquisition of newly-named Buzz) and Australia (Lauda), which will require higher levels of working capital.

Below are the expected levels of capex for the forecast period, based off of the revenue figures calculated in the previous section:

Source: Author, based on Ryanair's Financial Statements

Source: Author, based on Ryanair's Financial Statements

Terminal Value:

There are two ways in which the terminal value of Ryanair could have been calculated: either by the perpetual growth (Gordon Growth Model) approach which is favored in theoretical approaches, or the EV/EBIT(DA) approach, which is favored by industry. In order to decide which was the best approach to include in my analysis, I decided to perform a calculation of the terminal value of Ryanair using both approaches. Using the perpetual growth approach, the first issue that I encountered was at what level the perpetual growth level should be set (and for which length of time - finite or indefinite.) After experimenting with various assumptions and researching online, I came to the conclusion that this approach would be unlikely to give me a reasonable answer - as predictions for a perpetual growth rate would be little more than a random estimate. An approach I saw used elsewhere was to substitute the risk free rate of the currency (in this case -0.35% for the euro) in as the growth rate - but since the risk free rate is negative in this instance, this yielded results that are unlikely to hold true in the future.

After deciding that the perpetual growth method would be ineffective in this scenario, I decided to begin my analysis using the EV/EBIT(DA) method. Since the majority of the previous analysis has been carried out using EBIT (Operating Profit) - I decided that it would be more appropriate to use EBIT than EBITDA - for the sake of consistency.

Calculating the Enterprise Value of Ryanair (see below) was relatively straightforward, and then using the most recent actual EBIT figure gives us an EV/EBIT multiple of 10.56.

Source: Author, based on Ryanair's Financial Statements

This can then be used to calculate the terminal value of Ryanair (see the table above) by multiplying the EBIT multiple by the TTM EBIT figure (using trailing 12 months in order to give a current figure for terminal value.) The figure of €13,330 for terminal value makes up 75% of the value of the firm therefore, in order to be prudent, it has been necessary to go back and re-evaluate all the assumptions used in its calculation since it makes up such a large percentage of the total value of the firm.

Since this was a long and detailed process to get to the end value of the firm and hence calculate a valuation for Ryanair's shares, it is likely that (if any readers were to reattempt the calculation) they would come up with different answers based on the assumptions that I made. Please do let me know if there are any steps and/or assumptions that any readers feel are incorrect in the calculation.

Valuation:

Based on the analysis explained in the preceding paragraphs, I value Ryanair's shares at €12.53 (please see below) - a 41.3% uplift on current market values. Ryanair is traded on several exchanges, but the London Stock Exchange offers excellent liquidity, with c. €350m being traded in the previous month.

Source: Author, based on Ryanair's Financial Statements

Sensitivity to growth rate variation:

Below I have compiled a table that demonstrates how the calculated share price of Ryanair varies with the growth rate used. The row below the share price relates to the percentage upside vs. the market price of Ryanair's shares today for added readability.

Source: Author, based on Ryanair's Financial Statements

Even with an average of 0.5% growth over the next 5 years, there is a 30% upside vs today's market price of Ryanair's shares - and towards the right hand side of the table there is considerable upside vs current market prices. Despite an average of 7% growth over the next 5 years seeming very optimistic given the risks and factors discussed earlier, Ryanair was able to average 8% growth in the previous two financial years (between FY17 & FY18 and FY18 & FY19) - suggesting that the growth rate could potentially be greater than the conservative 2% estimate used in my calculations.

Risks:

As mentioned at the beginning of this article, there are several risks that Ryanair faces and will be likely to face in the forecast period that could cause a deviation from the figures that I have used in my calculations.

First, there are all the usual risks of operating an international airline business, including the risk of terrorism causing a fall in demand, economic pressure causing a reduction in demand for air travel, and a rise in oil prices which would cause a rise in cost of sales. Since Ryanair is a budget airline, these issues are amplified somewhat as it would take a marginally smaller decrease in demand/increase in cost of sales to push the airline into operating at a loss - as opposed to an airline that operates with higher margins.

Moreover, there is also a risk posed by Brexit - and since 14% of Ryanair's bases of operation lie within the UK (and do not fly domestically within the UK), this could be quite a significant risk. If Ryanair is unable to quickly obtain regulatory approval to fly from the UK to Europe, then this could cause a standstill for a large number of its routes, causing a large amount of lost revenue, the effect of which would unlikely to be able to be reduced by moving the spare capacity elsewhere in Europe. This is, of course, an issue for all airlines that fly between the UK and the continent, and the British Government is at present trying to avoid a 'no-deal Brexit,' however whether or not this is achieved by the 31st October deadline, remains to be seen.

Furthermore, there is also the risk that is posed by the grounding of the 737 Max aircraft, due to the integral part that these "game changer" aircraft played in Ryanair's short term cost-reduction strategy. Since Ryanair has a large number of these planes on order, and there has been little progress in clearing them for flight since the second tragedy in March 2019 - this is likely to be a concern for Ryanair shareholders for some time to come.

Conclusion:

Having conducted the above analysis over Ryanair, and taking into account the value of its future cash flows, current share price, valuation and aforementioned risks - I rate Ryanair as a buy. Consistently with other airlines, Ryanair's shares have behaved cyclically with the economy as demand for air travel fluctuates - and although the specter of a hard Brexit looms over the immediate future of the business, I still believe that there is alpha to be captured with Ryanair's shares trading at their current price. Gains are unlikely to come in the short term, but if the 737 Max issue and the effects of Brexit can be resolved within 3 years, then I believe that the share price could rise to pre-peak (August 2017, €18.60) levels - and potentially exceed this peak if the company able to overcome they key challenges that it faces.

Investors in Ryanair should be sure to consider the final terms of Brexit and the timing of the results of the 737 Max investigation, and adjust their positions in the airline accordingly - as these factors will serve as good indicators for the viability of Ryanair's cost saving/ growth strategy. Investors should be sure to consider their attitude to risk when building a portfolio containing Ryanair's shares, and be sure to adjust their allocation of funds between equity and fixed income securities accordingly.

Due to the significant number of assumptions that I have made throughout the DCF model, it is likely that the majority that read this article would come out with a different valuation at the end of the calculation. Please let me know if you disagree with any of my assumptions, or if you have any comments or criticisms of my methodology or how I have set out my analysis throughout the article.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.