Are Rolls-Royce shares too big a bargain to ignore?

Rolls-Royce shares have been on fire over the last six months. I’m considering whether I should add its shares to my portfolio.

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After climbing over 51% in the last six months some may believe that Rolls-Royce (LSE:RR) shares are entering into a bubble.

If we look at valuation metrics, though, this doesn’t seem to be the case. The shares are trading at a price-to-earnings ratio (P/E) of 11. This is roughly in line with the valuation of the FTSE 100 as a whole.

This doesn’t necessarily mean that its shares are undervalued. After all, being valued similarly to the Footsie would indicate a fair valuation.

However, I believe Rolls-Royce shares are still in bargain territory right now.

Concerns with debt

I do have one concern with the company as it has net debt amounting to £2.8bn on its balance sheet. This is not something to ignore as it could take a while to pay off.

However, although this presents some risk with holding Rolls-Royce shares, it looks like management is handling the debt repayments well. Net debt was £3.3bn at the end of 2022 and £5.1bn at the end of 2021. Therefore, there has been a significant headway in lowering debt levels.

Moreover, Rolls-Royce generated free cash flow of £356m in the first half of 2023. This is quite impressive considering that there was a cash outflow of £68m suffered in the first half of 2022.

As cash generation continues to improve, it should hopefully be able to pay off more of this debt.

Strong growth

The level of growth that a company is experiencing is a very important factor I take into account when determining whether to make an investment.

And Rolls-Royce hasn’t failed to impress with respect to this. Both the top and bottom lines are rapidly increasing.

Revenue increased 34% year on year to almost £7bn in the first half of 2023, way ahead of the £5.3bn generated in the same period last year.

Furthermore, profit before tax secured a huge turnaround over the same periods, from a loss of £111m last year to a profit of £524m this year.

The company is also performing with greater efficiency, with an operating margin of 9.7% this year compared to 2.4% last year. This particularly caught my eye, because the global economy continues to experience high inflation. The fact that Rolls-Royce is able to improve margins significantly in this environment is indicative that management is taking the company in the right direction.

And it’s worthy of note that this trend is expected to continue. Management has raised guidance for the remainder of the year to support this claim.

Now what

I started this article by stating how Rolls-Royce shares are valued similarly to the FTSE 100. However, if I look at the more sophisticated forward price-to-earnings growth (PEG) ratio, it becomes ever clearer to me that this shouldn’t be the case.

This metric takes the P/E ratio into account and factors for the level of growth a company is experiencing. For Rolls-Royce, this is 0.24. Anything below one is an indication that a stock is undervalued.

Rolls-Royce’s growth levels therefore make the stock too cheap to ignore in my eyes and if I had the spare cash today, I would buy its shares.

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.

Muhammad Cheema 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.

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