Six months ago, Morgan Stanley described Rolls-Royce (LSE:RR) shares were “woefully mispriced”. The bank said the earnings recovery was “much closer than the market has priced in, while earnings and cash flow are directly geared to the next leg of a global aviation recovery”.
At the time, the shares were trading for 95p. Now they’re priced at 91p. So was Morgan Stanley wrong, or have investors just missed an opportunity?
Is Rolls-Royce cheap?
It’s important to remember that a stock being cheaper than it was in the past does not necessarily mean that it’s cheap. And Rolls-Royce shares are down 23% over one year, and 62% over three years.
But that reflects the challenges the company has been through. It traditionally earns the majority of its income from its civil aviation segment and engine flying hour contracts. The company took on more debt during the pandemic and has sold business units to pay off some of that debt.
Instead, there are several metrics that we can look at to understand whether the stock is actually meaningfully undervalued. Near-term metrics suggest the company is cheaper than its peers.
| Rolls-Royce | Sector average | |
| Price-to-sales | 0.65 | 1.27 |
| EV-to-sales | 1.1 | 1.6 |
| EV-to-EBITDA | 12.62 | 11.71 |
| EV-to-EBITDA (forward) | 9.81 | 10.29 |
| Price-to-cash flow | 7.46 | 15.37 |
As we can see, in most cases, the metrics suggest that Rolls trades at a discount versus its peers.
The discounted cash flow (DCF) model often provides greater clarity, however it does require me to make estimates about future cash flows.
This model can take some time to calculate. But, thankfully, some experts have shared their DCF calculation for Rolls-Royce.
One DFC with a five-year exit suggests that the FTSE 100 stock is overvalued by 5.8%. That’s not good to hear as an investor. But, compared to other stocks in the sector, Rolls isn’t expensive.
Analysts suggest that Rolls’ competitors are overvalued, on a five-year basis, between 14.4% and 48.9%.
However, a DCF with an exit at 10 years suggests Rolls is undervalued by 49.6%. That’s really considerable. The analysts infer a share price range for 10-year exit of 88.8p to 238p. The selected figure being 136p.
Pros vs cons
Rolls still has £4bn in debt obligations — all on fixed interest rate terms — maturing between 2024 and 2028. That’s going to be a drag on profitability. And in the near term, civil aviation is yet to thoroughly recover to pre-pandemic levels.
In the last update, Rolls said that hours flown by its customers were now at 65% of 2019 levels. However, the reopening of the Chinese economy should provide a boost. The Emirates’ airline president recently said that when Covid-restrictions in China are lifted, the country will “unleash demand, the likes of which we will not have seen for a long, long time“.
Combine this with strong performance in the two other segments, power systems and defence, and I’m confident Rolls will push forward in 2023 and further into the future. This is why I’m buying more.
