Rolls-Royce Holdings (LSE: RR.) shares have done well in 2023. But they’re still down close to 50% over the past five years.
So, would I add Rolls to my Stocks and Shares ISA?
There are three things that would make me buy, assuming I had the cash ready.
1: The recovery is on
I want to see a firm recovery. The board aimed for positive cash flow by the second half of 2022, and achieved just that.
The firm now targets underlying operating profit this year of £0.8bn-£1bn. And free cash flow should reach £0.6bn-£0.8bn.
Those goals might be stretching. But I think the Rolls management team should be up to the task.
Forecasts show earnings rising in the next few years too. So I’d say there’s good evidence that the recovery at Rolls-Royce is on.
2: Balance sheet improvement
The huge debt that Rolls-Royce built up just to keep the lights on during the pandemic was scary. By the end of 2021, the balance sheet carried more than £5bn in net debt. Gulp!
But a year later, it was down to £3.3bn. A chunk of that was from cash raised through disposals, and that can’t happen every year.
But it shows me the firm has its priorities right. And I see a good chance of steady debt falls in the next few years.
So that’s two out of three.
3: Valuation is key
But it all comes down to valuation. And on that score, Rolls-Royce shares fail my test.
Headline forecasts put the price-to-earnings (P/E) ratio at about 34. In a turnaround year, just creeping into profit, that could be fine.
Forecasts see the P/E fall to 16 by 2025, as earnings start to climb back. And I reckon that could be make Rolls shares look good value. So why do I fail the stock on its valuation?
It’s all to do with this being a headline figure, which does not allow for debt.
The sum of the parts
I think it’s is a good example of why no single valuation measure should be used on its own. Some of us use the P/E, some are guided more by dividend yields, and others have their own favourites.
But the value of a stock depends on the sum of its parts.
We can adjust a P/E figure to take account of a firm’s debt. We work out what it could cost to buy the whole company and also pay off all the debt.
When I do that, I get an effective P/E for Rolls-Royce of about 42 for this year. And the 2025 P/E gets bumped up as high as 20.
Verdict
That doesn’t account for any falls in debt in the next few years. So, if earnings do grow, Rolls-Royce shares might be good value now.
I just don’t see anough safety margin. But I do see other stocks that look far safer and better value today.
The Rolls-Royce price might well keep on rising in 2023. In fact, I suspect it will. But for me it’s still just one to watch.
