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?

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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.

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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.

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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.

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 considered, so you should consider taking independent financial advice.

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