The Rolls-Royce (LSE:RR) share price has bounced higher as part of the FTSE 100’s recent mini-rally. At 154.9p per share, the engineer is now up 68% over the past 12 months.
Yet at current levels, its share price still looks dirt cheap. The firm trades on a forward price-to-earnings growth (PEG) ratio of 0.2. Any reading below 1 suggests that a share is undervalued.
But why are Rolls-Royce shares so cheap? And should I buy the business for my portfolio today?
Rock-bottom valuation
The PEG ratio isn’t as commonly used as the price-to-earnings (P/E) ratio. But fans of this metric argue that it provides a fuller picture of a stock’s valuation. This is because it also takes into account earnings growth.
Rolls-Royce is expected to increase earnings 155% year on year in 2023. This explains the company’s ultra-low PEG ratio.
Pleasingly, the company’s PEG multiple remains below the value watermark of 1 for the following two years as well. This reflects City predictions that annual earnings will rise 51% and 29% in 2024 and 2025 respectively.
Ready for a comedown?
Buying Rolls-Royce shares in anticipation of another share price spike might be the wrong strategy to take however.
The company’s transformation programme has been quite impressive. Significant streamlining and cost-cutting in the wake of Covid-19 is helping profits rise and delivering encouraging cash flows.
It swung from negative free cash flow of £1.49bn in 2021 to positive free cash flow of £505m last year. Rolls expects this to improve to between £600m and £800m in 2023 too.
A better-than-expected rebound in the travel industry has also driven the company’s strong recovery. This phenomenon is critical going forwards as its Civil Aerospace division makes significant profits by servicing aeroplane engines.
But it could be argued that its incredible price spike of the past 12 months reflects this. In fact, I’m personally worried that the rapid price ascent looks a little frothy. In other words, Rolls still has significant challenges to overcome, and any setbacks could cause its share price to crash back to earth again.
Why I’m avoiding Rolls’ shares
Just as the shares have benefited from the travel industry recovery, a sudden industry downturn could yank them lower again. This is a real possibility in my view as strong pent-up demand following the pandemic eases and the global economy cools.
This is especially dangerous for the engineer given the huge debts it still has on its books. Asset sales helped pull net debt almost £2bn lower over the course of 2022, to £3.3bn. But this is still uncomfortably high and could remain at elevated levels if market conditions worsen.
High inflation and supply chain issues in the aerospace industry are other threats that threaten Rolls’ profits and balance sheet recovery. If net debt remains high, questions over how the business can fund its capital-intensive, long-term growth programmes will become louder.
It was only six months ago that new chief executive Tufan Erginbilgic described Rolls-Royce as “a burning platform”. While its recent restructuring plan has been encouraging, I’m not willing to buy the FTSE firm for my portfolio right now.
