The Rolls-Royce (LSE:RR) share price surged 224% in 2023, making it the best-performing stock on the FTSE 100.
However, it’s getting close to its price target, which currently sits at £3.18. That’s just 6.4% above the current share price.
So, has Rolls-Royce peaked, or could it go further?
Value remains
Analysts have had to continually re-evaluate their position on Rolls-Royce. The company, which was considered over-leveraged and had to sell business units to fund debt a year ago, has beaten expectations again and again.
In addition to a well-planned restructuring, the firm has benefitted from a better-than-expected recovery in civil aviation. This remains the company’s largest and most important sector. Meanwhile, the engineering giant has seen solid orders across defence and power systems.
The company is forecast to report earnings per share (EPS) of 8p in 2023. In turn, this leads to a price-to-earnings (P/E) ratio of 37.5 times.
That’s clearly expensive, but Rolls is forecast to experience explosive growth in the coming years. In fact, EPS growth is forecast to average 71.9% over the coming three-five years.
In turn, this leads to a price/earnings-to-growth (PEG) ratio of 0.47. This infers that Rolls-Royce shares could be undervalued by as much as 53%.
The PEG ratio assesses a stock’s valuation by considering both its P/E ratio and expected earnings growth.
A PEG ratio below 1 suggests potential undervaluation, while above 1 may indicate overvaluation.
It’s among my favourite metrics, and aids investors in evaluating a stock’s worth relative to its earnings growth potential, providing a more comprehensive valuation metric.
Long-term tailwinds
As suggested above, Rolls-Royce generates the majority of its sales in three segments — civil aviation, defence, and power systems.
In some respects, the pandemic showed that the company could be too dependent on the civil aviation business. And that could be a turn off for some investors moving forward.
But it’s also worth highlighting that this is a sector with huge growth potential. In fact, the sky’s the limit with a booming global middle class fuelling demand for new jets.
However, Rolls exited the single-aisle jet market about a decade ago — the very segment predicted to dominate growth.
Airbus’s Global Market Forecast predicts demand for over 40,000 new commercial jets between 2023 and 2042. But only around 20% of these aircraft will be wide-body — this is where Rolls’s engines are typically used.
CEO Tufan Erginbilgiç says re-entering the booming single-aisle market is a possibility, but doesn’t see it happening for a decade.
The growth of the civil aviation market is a huge tailwind for Rolls, even if the company misses out on opportunities within the single-aisle segment.
Taking account of Rolls’s growth trajectory over the medium term, and the growth of the civil aviation market over the next two years, I believe this share price rally has some way to go.
