Rolls-Royce (LSE:RR) shares have rocketed in 2023. Yet at current prices of 242p, they might still be considered a FTSE 100 bargain.
Okay, the engine builder’s price-to-earnings (P/E) ratio of 25.2 times for this year isn’t that impressive. It sails above the forward average of 12 times for FTSE-quoted shares.
But on a price-to-earnings growth (PEG) basis, Rolls shares look ultra cheap. A prospective reading of 0.1 sits well below the benchmark of 1, suggesting that the company is grossly undervalued by the market.
Profits boom
The PEG is the preferred metric among many investors as it considers projected earnings growth. And here, City analysts expect the bottom line to swell by an impressive 375% year on year in 2023.
This is not all. Earnings are tipped to grow by around a quarter year on year in both of the following two years. Therefore, its PEG multiple remains under the value yardstick of 1 (at 0.9 and 0.8 for 2024 and 2025 respectively).
Strong demand in its end markets, combined with solid results from its transformation strategy, are driving profits sharply higher. Yet the company still has significant obstacles to overcome. So should I buy cheap Rolls-Royce shares for my portfolio?
The case for
One reason I’d invest is that, despite ongoing stress on consumers’ wallets and the spluttering global economy, the aviation industry remains in pretty good health.
In recent days United Airlines, Ryanair and Singapore Airlines have all released strong trading updates. This is critical news for Rolls given that its Civil Aerospace division is responsible for generating almost half of all revenues.
Meanwhile, noises coming from the defence sector — another key area for the London company — is also highly encouraging. BAE Systems announced in recent days that it racked up another £10bn worth of orders since the halfway point of 2023.
Finally, new chief executive Tufan Erginbilgiç remains committed to aggressive transformation and in October announced the cutting of an extra 2,000 to 2,500 jobs. Previous streamlining has already boosted its balance sheet and given cash flows a big lift.
The case against
But as we head into 2024, there are big risks to Rolls-Royce’s profits and its share price.
As I say, the civil aviation market has remained largely solid. But some chinks in the armour (such as Wizz Air‘s profit guidance cut last week) have appeared that suggest the tide could be turning. Continued stress in the global economy, along with rising airline fuel costs, pose a massive risk to the recovery.
Rolls faces problems elsewhere, too. Signs of stress have emerged at its Power Systems division, an area where orders sank 14% in the first half. Elsewhere, supply chain issues continue to rumble on across the business while cost inflation remains high.
Finally, the business still has a sizeable net debt pile (this stood at £2.8bn) as of June. And a large amount of its borrowings will need to be repaid by the end of 2025.
The verdict
While there are things I like about Rolls-Royce, I also fear that a bubble has formed around the stock following its whopping share price gains. Given the problems the company still has to overcome, I’d rather buy other cheap UK shares today.
