When the Rolls-Royce (LSE:RR) share price was below £3 at the start of the year, I thought it was clearly undervalued. Since then though, the stock is up 40%.
There’s no question investors who bought the stock in January stand to do better than anyone buying it today. But is there still a margin of safety build into the share price?
Investment returns
Since the start of the year, Rolls-Royce has seen its market-cap increase from £25bn to £35bn. And that’s arguably significant for a business that generated £1.7bn in free cash last year.
From an investment perspective, paying the equivalent of £25bn for a company earning £1.7bn a year in free cash implies a 6.8% annual return. At £35bn, the return is only 5%.
With interest rates at 5.25%, the difference is significant. A 6.8% return might be enough to justify the risk of investing in the company, where a 5% return may well not be.
Obviously, investors buying the stock at today’s prices aren’t expecting the business to generate £1.7bn a year indefinitely. They’re expecting growth – and they have reason to do so.
Growth
The idea that Rolls-Royce is going to increase its free cash flow isn’t just uninformed speculation. The firm’s management has set a target of £3bn a year over the medium term.
I can also see some clear catalysts that can move the company’s cash flows higher. An improving balance sheet should lead to lower debt costs, causing margins to expand.
Furthermore, nuclear appears to be a significant part of the UK’s renewable energy transition. And this could mean lucrative contracts for Rolls-Royce in the future.
If this translates into £3bn a year in free cash, the business will be earning an 8.5% return on its current market-cap. Even if interest rates stay where they are, that’s a more than decent return.
Margin of safety
What does this mean in terms of a margin of safety? I think there still is one, but it’s not as obvious as it was at the start of the year.
When the company had a market-cap of £25bn, the business arguably didn’t need to grow at all to be a good investment. With £1.7bn a year, it could offer a 6.8% return with no growth at all.
Rolls-Royce could miss its free cash flow targets and still be a decent investment for anyone buying the stock today though. If it reaches £2.7bn a year, rather than £3bn, that’s still a 7.7% return.
That means there’s still a margin of safety in the stock at today’s prices. But it’s more important to have a clear sense of the company’s growth prospects than it once was.
Still a buy?
Billionaire investor Warren Buffett’s a big advocate of the importance of a margin of safety when buying shares. And after the last five years, Rolls-Royce shareholders should know that better than most.
I think there’s still scope for the stock to be a good investment at today’s prices. But it’s much less obvious than it was at the start of the year.
