Journal of Business and Behavioral Sciences Volume 23, Number 1 issn 1946-8113 Spring 2011 inthis issue

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Only the Electronics group has a greater variability that air carriers. And once again, the volatility of operating profits of the airlines at 14.3% is almost double that of the Motor Carriers. The volatility of both the Railroads (3.3%) and the Maritime sector (2.5%) is pale in comparison.

How does this stack up to the actual performance of these industries? The Table IV is relevant. It shows the mean return on assets (ROA), the standard

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Because the air carriers evidence high operating ratios, and because of the implications of such high ratios, the airlines ought to consider the OPR as key input into several areas of decision making. One such area is the financial leverage decision. Management must decide on the extent to which the carrier can use long-term debt versus equity to finance assets. The use of debt introduces a new factor not considered in the above discussion. Interest on debt is a fixed charge which does not vary as operating profits change. As a direct result, debt finance will further introduce volatility into net profits after taxes. The total effect of the interaction of cyclicality and operating leverage with debt finance can be explosive. The high airline bankruptcy rate experienced is testimony to that fact (Gritta et. al., 2007; Davalos et al., 2005). The use of the operating ratio into future financing decisions would do much to warn of the excessive use of debt in the carriers‘ financial structures.

High OPRs should also serve as an early warning against unwarranted capacity increases merely to meet competition. In the past, carriers have frequently engaged in almost suicidal battles for market share. Since the addition of more capacity can tend to increase the OPR (as operating expenses will initially increase more than operating revenues), expansion should be carefully considered with the effects on volatility measured by the OPR. Given the fact that demand forecasting is difficult, and considering the cyclical vulnerability of this industry, both the planning of future capacity and the response to competitor‘s‘ scheduling needs to examined carefully in light of the OPR lest, in an effect to expand, profits are sacrificed in the process.

CONCLUSION

This paper has briefly considered the importance of the operating ratio in air transportation. As noted, it has a long and established history of application to several modes of transportation, including the airlines, motor carriers and railroads. As a measure of efficiency is it important to all firms because of its relationship to potential operating profit volatility. This is particularly true in air transportation, given the fundamental underlying instability of the nature of the business introduce by the deregulation of the industry several decades ago. The purpose of this paper was to explore the use of the OPR in a different context by linking it financial strategies management should follow. The motivation was to establish a link between this important ratio and profit volatility.

High operating ratios can, and often do, result in more unstable operating profits and lower and more volatile rates of returns on assets. An elasticity

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The significance of this study is that it can have direct application to the financial management strategies of any company. The debt/equity decision is crucial to financial solvency as noted above. In addition, carrier management should look at factors, such as the OPR, in determining future capacity and changes in that capacity. Others who should be interested in the results beside carrier management include credits, stockholders, and regulators such as the Department of Transportation (DOT).

1. 
   As far back as 1953, Rickenbacker argued for the use of the OPR, as opposed to the cost of capital standard set by the U.S. Civil Aeronautics Board in several regulatory hearings.
   
2. 
   Empirical evidence by one the above authors (Gritta, 1975) dating back into the 1970s, suggests that a 90.0% OPR is high. This was based on a comparative study of the airlines versus other (at the time) regulated groups including public utilities and a large sample of 74 industrial firms in sixteen different sectors of the economy.
   
3. 
   The ―constant cost‖ nature of the industry was first recognized by Frederick in his textbook on air carrier management way back in the early 1960s.
   

Journal of Business and Behavioral Sciences

Davalos, S., Gritta, R., & Adrangi, B. (2005). Deriving Rules for Forecasting Air

Approach, Journal of the Transportation Research Forum, XLVI (2), 40-54.

Frederick, J. H. (1961). Commercial Air Transportation, 4^th ed. (Homewood, Ill: Richard D. Irwin, Inc.), 331-333.

Gritta, R. (1975). An Unresolved Issue in Setting the Cost of Capital to the U.S. Domestic Airlines, Journal of Air Law & Commerce, XLI (Winter 1975), 65-74.

Gritta, R. (2005). Air Carrier Financial Condition: A Review of Discriminant, Logit and Neural Network Models for Measuring the Financial Fitness of the U.S. Airline Industry, Handbook of Transport Strategy, Policy and Institutions, Vol.VI, 1^sted. (2005). 547-560.

Gritta, R. Adrangi B., & Tatyanina, N. (2008). An Update on the Financial Condition of the U.S. Airline Industry since the Events of 9/11, Journal of the Transportation Research Forum, XLVII (2), 133-138.

Gritta, R., Davalos S., & Adrangi,B. (2006). A Review of Air Carrier Bankruptcy Forecasting Methodologies and Directions for Future Research, Credit and Financial Management Review, XII (3), 11-30.

Gritta, R., .Seal J., & Goodfriend, J. (2005). The Instability of the Profitability of the Major U.S. Domestic Airlines and Returns Over the Period, 1983-2001: A Comparison to Other Industrial Groups, The Credit and Financial Management Review, XI (4), 21-28.

Moyer, R. C., McGuigan J., & Kretlow, W. (2005) Contemporary Financial Management, 11^th ed. (Southwestern Publishing), 434-437.

Rickenbacker, Eddie. (1953). The Operating Ratio as a Yardstick for Measuring Airline Profits, Journal of Air Law & Commerce, XX(Summer), 253-268.

U.S. Civil Aeronautics Board, Domestic Passenger Fare Investigation, Docket 21866-8, The Fair Rate of Return, 1969.

The Value Line Investment Survey, various issues.

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National University

Modern finance relies on fundamental and technical analysis for stock valuation. A number of models and techniques such as zero growth model, constant-growth model, variable-growth model, free cash flow valuation model, book value, liquidation value, price/earnings multiples, etc. have been developed for stock valuation and making financial decisions. In addition, historical information and pattern development can be used for stock valuation.

Behavioral finance, on the other hand, focuses on psychology of making financial decisions. It acknowledges that people make biased and sentimental decisions and, therefore, there might be additional factors that should be taken into consideration in stock valuation.

This paper begins with a review of the current models and techniques for stock valuation. It is followed by a discussion of the key concepts of behavioral finance which contribute to biased and irrational financial decision making. Finally, the paper examines if the current stock valuation models and techniques can be improved by incorporating behavioral finance concepts.

Similarly, the value of common stock is derived from the expected cash flows discounted at the rate of return required by investors. The cash flows from common stock are received in form of dividends and, therefore, the valuation is based upon expected dividends. Some companies do not pay regular dividends but the valuation is still based upon expected dividends because the investors will receive dividends in the interim or at the time of liquidation of their investments or liquidation of the company.

The common stocks do not have a maturity date and, therefore, the dividends are infinite. The dividends are discounted using the required rate of return and the stocks are valued as follows:

Chawla

where

If we assume zero growth, the equation can be stated as follows: D1 P0 = rs where D1 = per share dividend expected at the end of year 1

For example, Chevron Corporation paid $2.66 per share dividends in fiscal year 2009. The valued of Chevron‘s stock, assuming 15% required rate of return and zero growth will be as follows:

D1

P0 = rs

15%

However, it is not realistic to assume that a company‘s returns will not grow at all in coming years. So, a realistic approach and widely used model is constant-growth model which assumes that the returns will grow at a constant rate. The constant-growth model can be stated as follows: ˆ = D 1

r_s-g

where g = growth rate and g = RR * ROE

RR = retention rate (earnings not distributed as dividends to shareholders)

ROE = return on equity

For Chevron Corporation, growth rate can be computed as follows:

g = RR * ROE

g = 67% * 17.98%

g = 12.05% Using the constant growth model, Chevron Corporation‘s stock can be valued as follows:

r_s-g

= (2.66 * 1.1205) = 15% - 12.05% = 97.72

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Free cash flow valuation model can be used if a company has not been paying dividends, does not have history of dividends, or is a new company. In that case, free cash flows (or cash flows available to investors), defined as operating cash flows minus investment in fixed and current assets, are discounted using weighted average cost of capital to arrive at the value of the company. Then, market value of debt and preferred stock is subtracted to arrive at the value of all of the common stock. Finally, the common stock value is divided by the number of outstanding shares to determine the value of a share.

For example, Chevron Corporation‘s cash flows from operating activities amounted to $29,632 million in 2008 (this year was selected because it represented the typical cash flows) and investments in fixed and current assets amounted to $17,081 million during the same year. So, its free cash flows were $12,551 million ($29,632 - $17,081) for the year ending on December 31, 2008. Assuming, its weighted average cost of capital was 6%, the value of the company is $209,183 million ($12551/6%). So, the value of the all of the common stock is $134,666 million ($209,183 - $74517 liabilities) and value per share is $67.19 ($134,666 / 2,004.23 outstanding shares).

Common stock can also be valued based upon the information available in the accounting books of a company. Book value of common stock is equal to the total assets recorded in the accounting books minus liabilities. Of course, the total book value should be divided by the number of outstanding shares to arrive at book value per share. Consider the following balance sheet of Chevron Corporation shown in Table 1.

Table 1
2009 2008 2007 2006 2005