Rolls-Royce shares are considered undervalued, but should I buy them?

Rolls-Royce shares are popular at the moment, but Oliver Rodzianko analyses how the company fundamentals fail to live up to the hype.

| 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.

Person holding magnifying glass over important document, reading the small print

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.

Rolls-Royce (LSE:RR.) shares are slightly undervalued, but there are better candidates and inherent weaknesses with the stock make me cautious as an investor. I do not believe the hype other investors are playing into.

Company operations

Rolls-Royce is one of the world’s best-known engineering companies. But the shares do not include the luxury automotive side of the business, which is a subsidiary of Bayerische Motoren Werke AG. The stock represents the company’s aerospace, marine, and energy businesses.

Removing BMW from the picture changes the equation significantly, and Rolls-Royce has some key issues that counteract it trading at what I would consider just below fair value. So I’m still not adding it to my portfolio at the current price.

Financials

Long-term revenue has been up and down, and has risen from £9bn to £13.5bn from 2008 to 2022, which is unimpressive. The company has also issued £907m of debt over the past three years. That being said, the operating margin as of June 2023 is 9.41%, and it is ranked better than 60% of companies in the Aerospace and Defence industry. Operating margin is on the rise after five years of decreases and negative margins from 2015 until 2020.

Opportunities and risks

Rolls-Royce has significant diversification, particularly amongst its three core divisions, and US government defence contracts, which creates some long-term certainty in terms of revenue. $1.8bn valued contracts for the US Department of Defence were reported in 2022, planning to span five years.

The company’s debt-to-equity ratio is currently -1.13, signalling the company’s liabilities significantly exceed its assets. The debt-to-equity ratio has been negative since 2018 and hasn’t improved over the long term since 2020. This severely concerns me, and I primarily won’t purchase shares due to the unrealistic fundamental changes required for a turnaround any time soon.

Valuation

The price-to-earnings (P/E) ratio is currently 12.19 and is ranked better than 86% of competitors in Aerospace and Defence. I performed a realistic free cash flow discounted cash flow analysis, with an 11% discount rate, a 5% 10-year growth stage and a 4% 10-year terminal stage. This resulted in a fair value of £2.31 and a margin of safety of 4.33%; the shares are currently £2.21. To me, this valuation signals that adding Rolls-Royce shares to my portfolio would be uncompetitive over the long term.

Personal take

My analysis points towards the fact that Rolls-Royce shares are selling at a good price but have unpromising future financial prospects. I consider the shares to have too much debt and some safe contracts, but a lack of momentum in terms of revenue and depressed equity metrics. 

Conclusion

Rolls-Royce shares are getting a lot of hype at the moment, but I believe this is unwarranted. I felt compelled to analyse the company to understand if it had a place in my portfolio as a value play, but I can’t find a compelling reason to buy them.

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.

Oliver Rodzianko 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

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Growth Shares

I bought 319 Scottish Mortgage shares for my SIPP in January. Here’s how they’ve done

Scottish Mortgage shares were out of favour in January so Edward Sheldon bought more of them for his pension. Was…

Read more »

Investing Articles

Is Tesco’s share price still a bargain after rising 26% over a year?

Recent results show Tesco is still growing its leading market share, and despite its share price gains this year, it…

Read more »

Investing Articles

Is this FTSE 250 gem the next big thing in defence sector shares?

This FTSE 250 defence firm was founded by the MoD, has seen its order book and profits swell, and is…

Read more »

Investing Articles

Here’s what the National Grid share price fall could mean for passive income investors

It's long been seen as one of the FTSE 100's best stocks for durable dividends. What does the recent National…

Read more »

Female florist with Down's syndrome working in small business
Investing Articles

£6,000 in savings? Here’s how I’d try to turn that into a £500 monthly passive income

With careful planning and patience, it’s not hard to earn a passive income with UK shares. Here’s one way to…

Read more »

Investing Articles

Here’s how I’d aim for a second income of £1,000 a month, with just £10 a day

How much do we need to build a decent second income? With enough time, we could do it with a…

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

Down 12% in a month, is this the FTSE 250’s most overlooked gem?

Our author thinks Kainos is one of the most overlooked FTSE 250 gems. Here's why he thinks the future could…

Read more »

Shot of a senior man drinking coffee and looking thoughtfully out of a window
Investing Articles

Just released: our 3 best dividend-focused stocks to consider buying before July [PREMIUM PICKS]

Our goal here is to highlight some of our past recommendations that we think are of particular interest today, due…

Read more »