Following a major ratings upgrade, Rolls-Royce’s share price looks a bargain to me

Despite a big price rise this year, its promotion to investment grade makes Rolls-Royce’s share price looks even more undervalued against its peers to me.

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Image source: Rolls-Royce plc

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Rolls-Royce’s (LSE: RR) share price has nearly trebled in 12 months. So it might seem peculiar to some investors that I still see it as a major bargain.

However, just because a company’s shares have risen sharply, doesn’t mean there’s no value left in the stock.

In fact, there could be a lot more value remaining than even the higher share price reflects.

Investment grade should drive new growth

Rolls-Royce committed at its Capital Markets Day on 28 November 2023 to achieving an ‘investment-grade’ profile. This is aimed at powering the next phase of business growth and boosting shareholder returns.

All companies are rated according to their overall creditworthiness by credit rating agencies. These range from various levels of ‘speculative’ quality at the bottom to various grades of ‘investment’ quality at the top.

An investment-grade profile gives a company an elite status in global financial markets. This allows it greater and more preferential access to capital, which can then be used to drive greater growth.

So, 14 March saw Rolls-Royce secure its first investment grade rating (BBB-) in almost four years from Standard & Poor’s ratings agency. The other major global ratings agency — Moody’s — still rates it Ba2 — two rungs below investment grade.

This ‘split rating’ between the two main agencies means the company can’t yet enjoy the full benefits of a full investment grade profile. But it’s a very good start, and it signals the strength of intent to achieve it.

To this end, December saw Rolls-Royce unveil financial targets to be achieved by 2027. These include £2.5bn-£2.8bn in operating profit, a 13%-15% operating margin, and a 16%-18% return on capital.

It also aims for free cash flow of £2.8bn-£3.1bn by that time. This cash pile can provide another major boost to growth.

One risk in the stock is that another pandemic would cripple its civil aerospace revenues (comprising 44% of its business). A major problem in any of its key defence sector products would also be very costly to it.

However, its 2023 results saw underlying profit increase by £938m to £1.6bn. Underlying operating margins rose from 5.1% to 10.3%. And underlying free cash flow jumped from £505m to a record of £1.3bn.

Are the shares a bargain?

Rolls-Royce currently trades on the key price-to-earnings (P/E) stock valuation measurement at 14.8.

Surprisingly to many, perhaps, this is still by far the lowest in its peer group, the average P/E of which is 30.3. Therefore, it looks a major bargain on this basis.

To find out how much of one it is, I used a discounted cash flow model, using several analysts’ valuations and my own.

This shows Rolls-Royce shares to be around 57% undervalued at the present price of £4.18. So a fair value would be about £9.72, although it doesn’t necessarily mean it will ever reach that level.

I already have a sizeable holding in competitor BAE Systems that I bought at a much lower price a long time ago. Like Rolls-Royce, its shares have performed extremely well, so I am happy with that position.

If I didn’t have that, though, I would certainly buy Rolls shares now. They still look very good value in my view, and the business seems well set for strong growth.

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.

Simon Watkins has positions in BAE Systems. The Motley Fool UK has recommended BAE Systems and Rolls-Royce Plc. 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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