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I was looking through some of the ASX’s best performing stocks when the performance of Qantas caught my eye. The shares are up 70% in the past twelve months and nearly 250% in five years.

Combine this with the recent IPO of its competitor Virgin Australia, and I wondered if we might be near something of a top in Qantas’ industry.

I thought it was time to touch base with Angus Hewitt on Qantas’ valuation. But as usual, let’s start with a quick primer on where Qantas makes its money.

Domestic and loyalty businesses key

As you can see below, Qantas made around $2.3 billion in what it calls “underlying EBIT” or earnings before interest and taxes in fiscal 2024.

Domestic flights under the Qantas banner provided just over a billion dollars of this underlying profit. Qantas International delivered $556m, while Jetstar Group and the loyalty business each contributed around $500m.

Qantas segments

Figure 1: Qantas operating segments. Source: Qantas annual report.

The main tailwind behind Qantas’ shares in recent years has been that profits have recovered strongly from the dark days of Covid.

Net profit after tax in fiscal 2024 were almost 50% higher than in 2019, and for fiscal 2025 we expect Qantas to report post-tax profits almost twice those seen in 2019.

Qantas profits by year

Figure 2: Qantas net profit by year. Source: Morningstar

This follows air travel numbers recovering strongly after the pandemic. Especially in Australia, where Qantas has also benefited from what Angus has labelled a “nadir” in domestic competition.

For much of the period, Qantas’ major competitor Virgin Australia has still been finding its feet after Bain bought it out of bankruptcy.

Then in 2024, smaller competitors Bonza and Rex exited the industry, providing more support to fares for the remaining players.

Which brings us to our first question. Can domestic operating conditions as favourable as these be expected to sustain for much longer?

Are such favourable domestic market conditions here to stay?

To put it bluntly, Angus does not expect conditions to remain so good in Qantas’s domestic operations forever. His thinking here is influenced by two defining qualities of the airline business.

Number one, the airline business has relatively low barriers to entry and a history of irrational pricing competition. Once new entrants take the relatively easy steps of leasing aircraft and landing spots, they often stop at nothing to fill seats.

Any new entrants or changes in capacity domestically could eventually put pressure on Qantas’ pricing and profit margins on domestic routes.

Number two, the airline business is cyclical. Good times come and good times go, with profits in the industry often hit significantly by factors - like the state of the economy or fuel prices - that are out of management’s control.

Put these things together and you get a bit of a lose-lose situation from here. Either the good times in domestic flights roll on a little longer and attract new competition, making the supply side of the equation less favourable. Or the cycle turns and hits Qantas on the demand side.

Either way, Angus thinks it is hard to see Qantas profits and returns on capital in its domestic business remaining so good for long.

Does Qantas deserve a cheap valuation?

Even though Qantas shares have risen 70% in the past year, it may continue to pop up in screens for ‘cheap stocks’ because of its relatively low P/E ratio.

Pitchbook currently has it on a forward price-earnings ratio of nine. This hardly sounds rich, however, Angus thinks the shares are actually materially overvalued.

This doesn’t stem from him being massively bearish on Qantas or its earnings outlook. Instead, it stems from his wariness of the airline industry and its history of destroying shareholder value.

Airlines sell a commodity product to highly price sensitive customers, Angus says. And they often do so against competitors that are hell-bent on filling their planes at whatever price makes that happen.

Airlines are also exposed to macro events – such as terrorist events, economic blips and pandemics – with the potential to take a serious chunk out of demand for travel. Not to mention fuel price swings.

Despite all of this, airlines must continually reinvest in newer planes. Otherwise they will fall behind other airlines on efficiency and customer experience.

Taken together, Angus says the airline industry is highly capital intensive, highly cyclical and highly competitive. Giving him little confidence that Qantas, or any other airline for that matter, can deliver economic profits across a cycle. Hence his No Moat rating.

How does this impact our valuation for Qantas?

Because of these factors, Angus thinks that future earnings in the airline business should be discounted at a higher rate.

Or in other words, a dollar forecast to be earned by the business one, five or ten years from now is worth a lot less than one already earned.

At recent prices of around $10.90, Qantas shares traded around 20% above Angus’ $9 per share estimate of Fair Value. So despite trading at a relatively low price-to-earnings ratio, Angus thinks the shares are actually very expensive at these levels.

To learn more about the process of valuing a share and the impact of discount rates on valuation, see this article by Mark LaMonica.

Previously on Ask the analyst:

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Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts’ independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.