Last week Rolls-Royce (LSE: RR) surprised with a net profit for the first half of 2021. The FTSE 100 aero engine manufacturer was seriously affected by the lockdown last year, since a big part of its sales come from the civil aviation business. And as we know all too well, 2020 was not exactly the year for travel.
So it was not expected to recover this fast. Moreover, Roll-Royce’s earnings woes date back far longer than just the pandemic. Even earlier it was clocking losses. So it looks like a pretty impressive feat to me.
Is the Rolls-Royce share price undervalued?
Its share price has already made gains since. And I think that if it is able to sustain its performance, it could rise higher. To assess this, I did a quick forecast based on its latest earnings. If its net profit remains unchanged in the second half of the year from the first half, it will end 2021 with £786m as statutory net earnings. At today’s market capitalisation, these numbers reflect a price-to-earnings (P/E) ratio of around 12 times.
However, the P/E of the FTSE 100 index as a whole is about 15 times. This means that Rolls-Royce’s earnings ratio is less than that for the index as a whole. Since, it is a stock with potential, now that travel is possible, I think its share price would gravitate closer to the average earnings ratio over time. At a P/E of 15 times for the company, its share price would rise by around 28% to 140p.
And this is when I have assumed that neither the company’s net profits nor the FTSE 100 index’s P/E ratio are likely to be any higher in the next few months. In other words, these are fairly conservative, if quite rough, estimates. It is possible for its share price to be far higher in another few months.
At the same time, I think it is also possible that its earnings upside may not continue. I say this for two reasons. One, the latest increase was unexpected because it was supported by a big tax credit, which made up for 71% of the profits. This item may or may not support profits in the future.
I think the numbers on underlying net profits or even operating profits are a better measure of the real upturn in its fortunes. These can help in getting a more rounded picture for the Rolls-Royce share price trajectory over time.
At the same time, the company is also undergoing restructuring, which includes a disposals programme, so headline earnings may still continue to surprise.
As a result, I think the Rolls-Royce share price can rise more which ever way I look at it, at least in the short term. However, for my long-term investments, I would still consider the stock carefully. And wait for reliable profits from its business, not repeating one-off bump-ups in earnings.
Manika Premsingh has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.