Is now the perfect time to buy Rolls-Royce shares?

Rolls-Royce shares remain in the dumps, but recent updates are making me feel more optimistic. Will 2022 be a turnaround year?

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Ever since the pandemic sent the aviation industry into a tailspin, we’ve seen investors trying to time their re-entry into Rolls-Royce (LSE: RR) shares. It resulted in several false starts, and I suspect that’s for one key reason.

I think the market has been responding based on short-term sentiment rather than long-term valuation. But I’m increasingly seeing signs that this could be changing. And I’m wondering if this is the right time for me to buy.

There’s been hope that when the company gets back on its feet after the pandemic, Rolls-Royce shares will recover to previous price levels. There’s a mistake there that I’ve seen many times over the years, and have been guilty of it myself.

Share dilution

Can the business get back to where it was in 2019? To raise cash through the slowdown, Rolls issued a whole load of new equity. That means future profits will be spread across billions more shares. For that reason alone, I don’t expect the same per-share valuation that Rolls had before the crisis.

Rolls-Royce also carries a lot more debt now. And that can make comparisons against historic valuation measures misleading.

I’ve calculated an enterprise value (EV) P/E for Rolls. This is a measure that accounts for debt, which headline P/E doesn’t. Ignoring debt can make the valuation look unrealistically low. I reckon it’s around 29 based on forecasts for this year, and on the current Rolls-Royce share price.

That’s not obviously cheap, but 2022 is still going to be be a very tough year. Forecasts suggest the P/E multiple, on an EV basis, could drop to around 13 by 2024.

Business strengthening

Rolls-Royce’s recent trading update gives me hope that that kind of valuation will prove justified. Much of the firm’s income comes from long-term service agreements for its large engines. Related flying hours rose 42% in the first four months compared to last year. Business flying hours remain strong.

The defence business is also performing well. And recent world events can surely only improve demand in that segment. Rolls said: “Our strong order backlog gives us confidence on revenue, profit and cash conversion against the headwinds of inflation and supply chain risk.”

The company expects a lower operating margin in 2022. But if it ends up being a turnaround year, I think we could see margins improving in 2023 and beyond.

Will I buy Rolls-Royce shares?

If Rolls-Royce can generate positive cash flow by the end of this year, as planned, I think the risks to the business itself will be significantly reduced.

But I see the risks to the company’s valuation, and to the share price, remaining high. The biggest is debt, and I really want to see that coming down. If cash flow starts to turn into debt reduction over the next two years, I reckon the outlook for Rolls-Royce shares could brighten.

I don’t expect any quick recovery, for sure. And huge uncertainties remain. But Rolls-Royce definitely remains on my list of possible medium-term buys.

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.

Alan Oscroft 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.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »