Running head: FINANCE ANALYSIS 1 FinanceAnalysisNameInstitution

Optimal investment involves carrying out effective analysis ofvarious investment opportunities and selecting one with a higherreturn at a low risk. Evaluating the investment opportunity involvesanalyzing the intrinsic security value and other external factorsthat affect the company. When composing an investment portfolio aninvestor considers securities and investment vehicles that will meethis/her objectives. While evaluating the stock of the company some ofthe factors considered include peer performance, historicalperformance, risk, and fundamental factors. Evaluating these factorsreveals the risk-and-return of the potential investment. This reportaims at evaluating two companies operating in the same industry witha view to selecting the company that will offer the best investmentreturn for considerably the same level of risk. The two companies,Southwest Airlines and American Airlines operate in the air travelindustry. The report commences by looking at the backgroundinformation about the two companies.

Background to theCompanies

  1. Southwest Airlines

This is a main airline in U.S. and serves as the world largestlow-carrier. The company was founded in 1967 and has it`sheadquartered in Dallas, Texas. Southwest Airlines employs over 46,000 people and operates more than 3, 800 flights every day. As atJune 2016, Southwest Airlines had 98 destinations located in 40states and a fleet size of 722 airplanes. By 2015, the company hadtotal assets valued at US $ 21.31 billion, and total equity valued atUS $ 7.36 billion. In the same year, Southwest Airlines generated US$19.82 billion in the form of revenue and operating income amountingto US 4 4.12 billion (Airlines &amp Roadway, 2014). The company islisted on the New York Stock Exchange, where it is traded as NYSE:LUV. The company has maintained its low-cost strategy, despitecriticism of low-quality services. However, over the years, thiscarrier has continued to excite its shareholders with excitingprofitability despite various economic factors that have dealt amajor blow to the airline industry not only in the USA but all overthe world (Southwest Airlines Inc., 2016).

  1. American Airlines

American Airline has it`s headquarter in Fort Worth, Texas. Thecompany commenced operations in 1936. It operates extensive domesticand international network. It is currently the world largest airlinein terms of revenue generation and fleet size. The company is secondonly to United Airlines in terms the number of destinations served.American Airlines is the founding member of the One World AirlineAlliance and plays the role of coordinating services, fares, andscheduling with other alliance partners such as British Airways andJapan Airlines across both transpacific and transatlantic markets(Willoughby, 2014). The company is a fully owned subsidiary of theAmerica Airlines Group. It is listed on the American Stock Exchange(NASDAQ) where it is publicly traded as (NASDAQ: AAL) and form partof the American Airlines group. As such, in the evaluation of theviability of this company as a possible investment opportunity, theperformance of the American Airlines group is evaluated. AmericanAirline Group was established in 2013 following a merger of AMRCorporation with US Airways group. The group generated total revenueamounting to US 4 10.99 billion and operating income amounting to US$ 6.204 billion in 2015 from the total assets valued at US $ 5.635billion (American Airlines Group, Inc., 2016).

SouthwestAirlines and the American Group Airlines Analysis

  1. Financial Performance Analysis

Graph 1.0 below shows the net income of the Southwest Airlines andthe American Group Airline. The graph shows that Southwest Airlineshas a more sustainable income than the American Group Airlines.However, the American Airlines group has seen 73.25% income growthbetween 2011 and 2015. High growth in revenue and net income for thecompany was contributed by the 2013 merger that led to the formationof the current group. Before the major, the company was operating ata loss. The merger has enabled the Group to derive synergy. However,even though American Group has more net income than the SouthwestAirlines for the year 2015, Southwest Airlines financial performanceis more sustainable. Financial sustainability is used as a keydeterminant of future business sustainability and as such givenSouthwest Airlines’ high financial sustainability, the stock of thecompany would be more appealing for risk-averse investors than thatthat of the American Group Airline (Yahoo Finance 2016).

Graph 1.0 net incomefor the Southwest and America group Airlines

  1. Ratio Analysis

Financial ratio analysis is a useful tool that helps the analyst tounderstand financial result and trend over time, and offer keyindicators relating to the performance of the organization. Ratioanalysis gives the strengths and weaknesses of the company, whichhelp to guide investment initiatives and strategies. This analysisevaluates profitability, sustainability, and liquidity and leverageratios for the Southwest Airline and American Group Airlines(Belkaoui, 2008). The profitability ratios show how well the companyis performing for a given period, suitability and operationalefficiency ratios look at how the company is utilizing the assets andmanaging liabilities, liquidity ratios assesses the ability of thecompany to meet its operational obligations, and the leverage ratiosevaluate the organizational risk and the extent to which it islevered.

  1. Current Ratio

This ratio examines the ability of the entity to meet its short-termobligations when they fall due (Keown, 2004). A ratio of less thanone indicate liquidity issues, a ratio of higher than two indicatesexcess cash, and the current ratio between 1.2 and 2.0 is consideredsufficient.

Current ratio =current assets / current liabilities

Current ratio

&nbsp

Southwest Airlines

American Airlines Group

Year

2013

2014

2015

2013

2014

2015

Current assets

4456000

3927000

4024000

14323000

11750000

9985000

Current liabilities

5676000

5923000

7406000

13806000

13404000

13605000

Current ratio

0.79

0.66

0.54

1.04

0.88

0.73

The liquidity of the two companies dropped over the three years from0.79 to 0.54 for the Southwest Airlines and from 1.04 to 0.73 for theAmerican Group Airways. The two companies cannot meet theirshort-term obligations using the current assets, which is anindication of liquidity issues. However, American Group Airline has amore healthy and stable liquidity than Southwest Airlines. The twocompanies had a lower liquidity than the industrial average currentratio of 1.08 (Yahoo Finance, 2016).

  1. Net Profit Margin

Net profit marginindicates return generated by the company per every dollar of sales.It indicates the ability to cover the operating costs (Keown, 2004).

Net profit margin =Net profit over the total sales

Net Profit Margin

&nbsp

Southwest Airlines

American Airlines Group

Year

2013

2014

2015

2013

2014

2015

Net Profit

754000

1136000

2181000

-1834000

2882000

7610000

Total Sales

17699000

18605000

19820000

29743000

42650000

40990000

Net Profit margin

0.04

0.06

0.11

-0.06

0.07

0.19

The two companies improved the amount of money that they convert toprofit with Southwest Airline improving from $0.04 income per dollarof sales in 2013 to $ 0.11 per dollar of sales in 2015. Similarly,American Group Airlines improved its performance from a net profitmargin of -0.06 in 2013 to 0.19 in 2015. On average American groupAirlines improved its ability to generate profit from sales at arelatively higher rate than the Southwest Airlines. Compared to theindustrial net margin profit of 0.19 Southwest Airlines performedpoorly while the American group Airlines performance was on average.

  1. Return on Assets

The ratio looks atthe money produced for every dollar invested in asset (ability toconvert assets to profit). A low ratio relative to industry indicatescompetitors are more efficient (Keown, 2004).

Return on assets =Net profit over the total assets

Return on assets

&nbsp

Southwest Airlines

American Airlines Group

Year

2013

2014

2015

2013

2014

2015

Net Profit

754000

1136000

2181000

-1834000

2882000

7610000

Total assets

19345000

19723000

21312000

42278000

43225000

48415000

Net Profit margin

0.04

0.06

0.10

-0.04

0.07

0.16

Southwest Airline increased the amount generated per every dollarinvested in the asset from 0.04 in 2013 to 0.1 in 2015. Similarly,American Group Airline improved from a return on assets ratio of-0.04 to 0.16. The comparison of the two companies shows thatAmerican group Airline has a higher ability to generate income perevery dollar invested in assets compared to the Southwest Airlinesbut the two companies performed well than the industrial average of0.05.

  1. Return on Equity

This ratio shows therate of return on shareholders’ investment (return per every dollarinvested in equity) (Palat, 2006).

Return on equity =Net profit / Shareholders Equity

Return on equity

&nbsp

Southwest Airlines

American Airlines Group

Year

2013

2014

2015

2013

2014

2015

Net Profit

754000

1136000

2181000

-1834000

2882000

7610000

Shareholders’ equity

7336000

6775000

7358000

-2731000

2021000

5635000

Net Profit margin

0.10

0.17

0.30

0.67

1.43

1.35

The industrialaverage return on equity for the year 2015 was 0.89. AmericanAirlines Group outperformed the industry and performed better thanthe Southwest Airlines, which underperformed the market with returnon equity of 0.3 in 2015. The evaluation indicates American GroupAirlines has a stronger financial performance than Southwest Airline.

  1. Total Asset Turnover

The ratio evaluateshow efficiently the company generates sales for every dollar investedin asset (Palat, 2006).

Total assets turnover

&nbsp

Southwest Airlines

American Airlines Group

Year

2013

2014

2015

2013

2014

2015

Revenue

17699000

18605000

19820000

29743000

42650000

40990000

Total assets

19345000

19723000

21312000

42278000

43225000

48415000

Net Profit margin

0.91

0.94

0.93

0.70

0.99

0.85

The ability ofSouthwest to generate sales on assets improved between 2013 and 2015while that of the American Airlines group declined gradually. Thisshows that southwest has a better sales strategy than the AmericanAirlines Group. Southwest generated higher assets turnover thanAmerican Group Airline. The average industrial assets turnover forthe three years (2013 through 2015) was 0.88, which shows thatSouthwest beat the industry while American Airlines Group performedbelow the industrial average.

  1. Debt to Equity

The ratio comparesfund provided by the lenders and capital invested by the shareholders(owners) (Keown, 2004).

Debt to Equity =Total debt divided by the total equity

Debt to equity

&nbsp

Southwest Airlines

American Airlines Group

Year

2013

2014

2015

2013

2014

2015

Total debt

12009000

12948000

13954000

13806000

13404000

13605000

total equity

7336000

6775000

7358000

-2731000

2021000

5635000

Net Profit margin

1.64

1.91

1.90

-5.06

6.63

2.41

In 2015, American Group Airline relied more on debt capital comparedto the Southwest Airlines. In the same year, the industrial averagedebt to equity was 1.94. This shows that Southwest Airlines hadslightly lower debt than its peers and lower than American GroupAirlines. High level of debt increase risk exposure and financialencumbrances, however, using very small amount of debt prevents thecompany from enjoying tax benefit. The evaluation of the twocompanies above indicates that Southwest Airlines has more balancedcapital structure compared to American Group Airlines, which has morethan two times the level of debt compared to the equity.

  1. Share analysis

  1. Share Valuation

The intrinsic valueof the two companies is carried out using the discounted cash flow(Schlichting, 2009). The intrinsic value for the American AirlinesGroup projected using the free cash flow:

Intrinsic Value =Growth Multiple × Free Cash Flow + Total Equity × 0.8) / SharesOutstanding

= (9.5×-973.8 + 4710 × 0.8) / 611.5

= -9.0

The intrinsic valueof the American Group Airline is -9.0 given by the FCF valuation.This shows that the company is highly overvalued in the market whereit is trading at stock price of $29.4. The intrinsic value for theSouthwest Airlines projected using the free cash flow is given by:

Intrinsic Value =Growth Multiple × Free Cash Flow + Total Equity × 0.8) / SharesOutstanding

= (14.9 ×1051 + 7496 × 0.8 / 648.0

= 33.4

As at 7th July 2016,the share price of Southwest Airlines was $ 39.35. The projectedintrinsic value for the company is $ 33.6. This means that theintrinsic value/projected FCF ratio is 1.2. Given that the marketprice is higher than the determined intrinsic value, the price can beconsidered overvalued.

  1. Technical Analysis

Technical analysis evaluates a security using statistics obtainedfrom trading activity such as volume and price movement. Technicalanalysis tries to analyze the intrinsic value of the security byfocusing on charts of volume and price movement to forecast futurechanges (Peterson &amp Fabozzi, 2012). The share price for the twocompanies over between July 2016 and January 2014 is shown in thegraph 2.0 below (Yahoo Finance, 2016a: Yahoo Finance, 2016b)

The graph indicatesthat the American Group Airline outperformed the Southwest Airlinebetween the year 2014 and February 2015. On average, the share priceof the American Group Airline has been more volatile than that of theSouthwest Airlines. However, the historical prices indicate thatAmerican group Airline has a higher potential of registering morecapital gain for the shareholders than the Southwest Airlines.

  1. Fundamental Analysis

Fundamental analysis evaluates the intrinsic value of the security bylooking at the financial, economic and other industrial quantitativeand qualitative factors (Schlichting, 2009). The method considers allfactors that affect the value of the security includingcompany-specific and macroeconomic factors (Vandyck, 2006). Somemajor factors that have affected air travel industry includeplummeting of global oil prices, European financial crises, andpolitical instability in various countries around the world. Thesefactors have affected the two companies a similar way.

  1. Risk Analysis

Risk analysis is the process of evaluating potential problems whichcould undermine major initiatives by business. Identifying andestimating the level of risk helps in managing, mitigating, andhedging the risks (Palicka, 2012). In analyzing stock risks, beta isused. Beta indicates the volatility of the security relative to themarket proxy. A beta of more than 1 indicates that the company’sstock is more volatile than the average market volatility. The betafor the Southwest Airlines is 0.3 while that of the American Groupairlines is 3.13. This shows that the share price of the Americangroup Airline is more volatile compared to that of the West Airlines.On addition to this, American Group Airline share price is morevolatile than the market. This is because its beta exceeds one.

The results show that American Airline has a higher level of exposureto risk than the Southwest Airlines. On the other hand, the standarddeviations for the Southwest Airlines and the American Group are0.018 and 0.24 respectively. The standard deviation elucidates theextent to which the company returns deviates from the mean return.American Group has a high returns’ deviation from the mean and thusit has a high risk. Assuming a higher risk is supposed tocommensurate with the higher return to the investor. Given thatAmerican Group has a higher investment risk, it would be optimal forthe risk averse investor to invest in the Southwest Airlines.

Conclusion andRecommendation

A sustainable investment requires effective management and planning.Investment analysis reveals the investment opportunity that wouldgenerate optimal returns. The evaluation of the two companiesindicates that it would be recommendable to invest in the stock ofthe American Group Airline, which has a more financial stability,higher income, and higher return to the investors. Southwest Airlineswould be ideal for relatively risk-averse investors who want lowreturns with low risks.

References

Airlines, S.,&amp Roadway, U. L. (2014). Southwest Airlines.&nbspFacebook.Com.

American Airlines Group, Inc. (2016). 2015 financial report. AmericanAirlines Group, Fort Worth, Texas.

Belkaoui, A. (2008).&nbspFinancialanalysis and the predictability of important economic events.Westport, Ct: Quorum.

Keown, A. (2004).&nbsp. Beijing: Qinghua University Press.

Palat, R. (2006).&nbspUnderstandingfinancial ratios in business: a practical guide for business finance&amp banking. Mumbai: Jaico Pub. House.

Palicka, J. (2012).&nbspFusionanalysis merging fundamental, technical, behavioral, and quantitativeanalysis for risk-adjusted excess returns.New York: McGraw-Hill.

Peterson, P. &amp Fabozzi, F. (2012).&nbspAnalysisof Financial Statements. Hoboken: John Wiley &amp Sons.

Schlichting, T. (2009).&nbspFundamentalAnalysis, Behavioral Finance and Technical Analysis on the StockMarket Theoretical Concepts and Their Practical SynthesisCapabilities. München:GRIN Verlag GmbH.

Southwest Airlines Inc. (2016). Financial report for the year 2015.Southwest Airlines Inc. Dallas, Texas.

Vandyck, C. (2006).&nbspFinancialratio analysis: a handy guidebook. Victoria, B.C:Trafford

Willoughby,J. (2014). The new American airlines goes for the gold.

Yahoo Finance (2016a). American Airlines Group Inc. (AAL). Retrievedon 8th July fromhttps://finance.yahoo.com/q/hp?s=AAL&ampa=00&ampb=1&ampc=2014&ampd=06&ampe=8&ampf=2016&ampg=d

Yahoo Finance (2016b). Southwest Airlines Co. (LUV). Retrieved on 8thJuly fromhttps://finance.yahoo.com/q/hp?s=LUV&ampa=00&ampb=1&ampc=2014&ampd=06&ampe=8&ampf=2016&ampg=d