Is Rolls-Royce’s share price too cheap to ignore?

Rolls-Royce’s share price currently commands a rock-bottom PEG ratio. But is the FTSE 100 firm still too risky to buy even at current prices?

| 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.

Young black man looking at phone while on the London Overground

Image source: Getty Images

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.

The Rolls-Royce (LSE:RR) share price has risen an impressive 54% in the year to date. However, even at current prices of 149p per share, the FTSE 100 engineer looks cheap on paper.

City analysts think company annual earnings will soar 156% in 2023. This means its stock changes hands on a forward price-to-earnings growth (PEG) ratio of 0.2.

Any reading below one indicates that an equity is undervalued.

So are Rolls shares one of the FTSE Index’s best bargains? Or does the engine builder command a low valuation for good reason?

Another bright update

Those exceptional earnings forecasts reflect the airline industry’s impressive recovery from the pandemic. And brokers don’t think Rolls-Royce’s expected bottom-line explosion this year to be a one-off.

Yearly earnings are expected to rise an extra 48% and 32% in 2024 and 2025, respectively.

A robust AGM update this week from Rolls illustrates the solid progress it has made of late. In it the company maintained its 2023 operating profit guidance of £800m to £1bn. It also claimed it remains on course for free cash flow of £600m to £800m.

In other news, between January and April, total flying hours of its engines hit 83% of 2019 levels, putting it on course to reach its 80% to 90% range for the full year. This is good news as the business makes significant revenues from servicing large engines on long-haul commercial aircraft.

Rolls also racked up new contract wins, including its biggest-ever order for Trent XWB-97 engines. Across its other operations the company has continued to rack up contracts at its Defence division. And at Power Systems revenues have continued to rise, order intake remains high, and pricing on new orders is improving, the FTSE firm said.

Travel recovery stalling?

Yet despite Rolls’ hot streak I’m still not tempted to buy its cheap shares. The business faces a raft of potential obstacles that could throw its recovery off course and affect shareholder returns.

My chief concern is a possible downturn in the civil aviation market. Weak economic conditions mean that demand for plane tickets among holidaymakers and business travellers could cool considerably.

Heathrow Airport said this week that “passenger growth may be levelling off,” with the recovery stabilising at between 93% and 95% of 2019 levels in the first four months of the year. Signs of similar slowdowns in other major airports could leave Rolls’ robust earnings forecasts looking unrealistic.

Other dangers

Supply problems and higher-than-normal cost inflation are other problems that look set to trouble profits. Indeed, in its AGM update, Rolls-Royce noted that “supply chain management remains a key operational challenge for us as original equipment and aftermarket services volumes increase”.

I’m also concerned about the company’s high levels of debt.

Improved trading and cost-cutting helped reduce net debt to £3.3bn at the end of 2022. But Rolls’ transformation still has a long way to go, and with its markets in danger of weakening again, the outlook for future dividends and the funding of its development programmes remains uncertain.

All things considered, I’d rather buy other cheap FTSE 100 shares today.

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.

Royston Wild 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

2 bargain investment trusts with yields over 7% to consider buying for a Stocks & Shares ISA

Roland Head highlights two high-yield opportunities that could deliver attractive returns inside a Stocks and Shares ISA.

Read more »

Investing Articles

How I’m targeting a £10,000 second income from dividend shares

Dividend shares are a great source of extra cash. But Stephen Wright thinks investors looking to finance a comfortable retirement…

Read more »

Investing Articles

A once-in-a-decade chance to buy FTSE shares for passive income!

Even with the market rally, many FTSE shares are trading at dirt cheap valuations, creating a rare opportunity to lock…

Read more »

Investing Articles

Here’s how many Tesco shares I’d need for £200 a month in passive income

Our writer takes a look at Tesco shares to assess whether they seem like a worthwhile option for his dividend…

Read more »

Portrait of elderly man wearing white denim shirt and glasses looking up with hand on chin. Thoughtful senior entrepreneur, studio shot against grey background.
Investing Articles

At 58p, is Lloyds actually a penny stock? And is it a buy today?

Lloyds continues to trade below a pound, but now that interest rates have surged, will the bank break through this…

Read more »

Investing Articles

£20k in savings? Here’s how much passive income I’d earn from these 7 dividend shares

Charlie Carman explains how he'd target a mighty passive income stream by investing an entire ISA allowance in a diversified…

Read more »

Investing Articles

The Bank of England predicts another stock market correction! Who cares?

Concerns are on the rise as the UK’s central bank anticipates a sharp correction in asset prices. But can investors…

Read more »

Young woman working at modern office. Technical price graph and indicator, red and green candlestick chart and stock trading computer screen background.
Investing Articles

3 FTSE 100 stock bargains to consider buying right now

There may be a valuation re-rating coming for large-cap FTSE 100 companies, so I'm targeting some of these bargain stocks…

Read more »