Why the Rolls-Royce share price is up, down, flying around

The Rolls-Royce share price has been extremely volatile of late. It’s an unloved stock but arguably a fundamentally sound and undervalued business.

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Preparing for this column on Thursday (24 March), I had in mind devoting it to the three FTSE 100 shares that could be bought for under a pound.

These blue-chip rarities were Lloyds at 48.75p, ITV at 81.4p and Rolls-Royce (LSE: RR) at 92.3p.

However, late Friday afternoon, the Rolls-Royce share price skyrocketed. The shares soared almost 20%, finishing the week at 110.1p.
 
I’ll return to Lloyds and ITV in a future column, but I’m going to focus on Rolls-Royce here.

The Friday surge

On Friday 25th, Bloomberg reported that Air India could be set to place a big order for Rolls-Royce-powered Airbus A350 jets.
 
It quoted Chris Davie, a Rolls-Royce senior vice president in Asia, speaking on the sidelines of the Hyderabad airshow: “I think they are looking at something up to 30 aircraft, could be as big as that, which is a big order. A really big order.”
 
Encouraging news, but Bloomberg’s report was time-stamped 11:03 GMT and the RR share price moved only modestly higher by midday.
 
The real catalyst for the late-afternoon surge was a 16:15 GMT alert that went out to subscribers of Betaville Intelligence, a niche service focused on merger-and-acquisition (M&A) activity.

Uncooked

Betaville advised that Rolls-Royce may be involved in a “significant corporate transaction” with an unknown suitor.

The alert was at the lowest level on Betaville’s confidence scale of ‘uncooked’, ‘rare’ and ‘well done’. Although, to be fair, its previous uncooked alert flagged up takeover interest in FTSE 250 firm Homeserve.

And before the day was out, Brookfield, a big Canadian infrastructure investor, confirmed it was “in the early stages of considering a possible offer.”

Rumour mill

As I’m writing (Monday evening), there’s been no statement from Rolls-Royce or any would-be suitor. And the share price has fallen back over 10% from Friday’s close, ending the day at 98.4p.
 
Maybe there’ll have been developments by the time you’re reading this. Or maybe not, and the excitement will have fizzled out, as happens so often.
 
There are a number of reasons, though, why I’m not surprised the rumour cropped up:

  • M&A activity has been rife over the last year or so.
  • Rolls-Royce has been the subject of rumours in the past.
  • Chair Anita Frew is relatively new and the company also recently announced chief executive Warren East will step down at the end of the year. Such circumstances can be a catalyst for a predator to make a move.
  • The shares of many defence companies have risen strongly since Russia invaded Ukraine, potentially putting them in a good position to swoop for weaker rivals.

And when a quality business is temporarily struggling and priced by the market at a discount to its intrinsic value, there’s always likely to be interest from trade buyers.

Valuation

Analysts aren’t agreed on whether Rolls-Royce is a quality business these days. But despite its problems, and what seem to be perennial restructuring programmes, I personally think the underlying business is fundamentally sound.
 
The company expects to generate “modestly positive” free cash flow (FCF) in 2022. And management has spoken before of a medium-term target of £750m.
 
At a share price of around £1, that would give a FCF yield of 9%. In the past, when the market had more confidence in business, it priced the stock at a yield as low as 3%.
 
As such, Rolls-Royce could deliver a high investment return, if it were to generate FCF of £750m and market sentiment were to swing back to valuing the stock at a yield nearer 3%.
 
Still, there’s no guarantee the company will make the progress envisaged. Additionally, there’s a risk the new chief executive could reset expectations to a more modest level.

Trading game

Short-term traders who got in quick on Betaville’s RR alert, and sold on the spike in the shares, will no doubt have got a kick out of a quick double-digit return.
 
Equally, those who bought late in the day in anticipation of a further rise on Monday, and then cut their losses when the shares opened 10% down, will doubtless be kicking themselves for getting ‘spiked’.

Foolish approach

As a Foolish investor, the speculative short-term trading game is not one I want to play.

I’m interested in the far more substantial returns available over longer periods from correctly identifying good businesses trading below their intrinsic value. These may include some companies that are going through a difficult period and are unloved by the market.

I think Rolls-Royce is potentially such a stock… And what of those other sub-£1 blue chips I mentioned, Lloyds and ITV?

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

The Motley Fool UK has recommended Lloyds Banking Group, ITV and Homeserve. 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.

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