Are Rolls-Royce shares simply overvalued?

Rolls-Royce shares just keep on gaining, but are they starting to look overvalued? Dr James Fox takes a closer look at the engineering giant.

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Few stocks globally have outperformed Rolls-Royce (LSE:RR) shares over the past 18 months. Only a handful of companies, including Super Micro Computer and GigaCloud Technology, have seen stronger growth. But is the stock now overvalued? Personally, I don’t think so and here’s the data to prove to it.

Share price targets

One way of working out fair value is by looking at share price targets or the consensus share price target. Currently, the average share price target for Rolls-Royce is just £4.40. That’s only 3.9% above the current share price.

However, it’s worth noting that sometimes analysts struggle to keep their share price targets up to date. After all, over the past 18 months, Rolls-Royce has surprised us positively on several occasions. In fact, it’s often worth discounting share price targets that were published more than three months ago.

Despite trading at just 3.9% below the average target share price, Rolls-Royce has eight ‘Buy’ ratings, four ‘Outperform’ ratings, four ‘Hold’ ratings, and just one ‘Sell’ rating.

Establishing fair value

City and Wall Street analysts often get it right, but that doesn’t mean we can’t do our own research to validate their positions and establish our own. Personally, I’m more bullish than the average share price target.

Looking forward, we can see that Rolls-Royce is trading at 24.5 times forward earnings. That’s considerably above the average price-to-earnings (P/E) ratio for the FTSE 100 — around 14 times — but it’s not necessarily expensive for the sectors in which it operates — civil aerospace, defence, and power systems.

These are sectors with incredibly high barriers to entry and where it is very challenging to break the status quo. That also means Rolls-Royce has strong pricing power allowing it to build out its margins — something the current management is very keen on doing.

Moreover, this 24.5 times earnings isn’t particularly expensive given the growth potential Rolls-Royce offers. Analysts are expecting earnings to grow by a remarkable 33.5% per year over the medium term. As a result, the P/E ratio will fall — according to forecasts — to 20.3 times in 2025, 21.2 times in 2026, and 17.3 times in 2027. Of course, forecasts can change.

This also results in a price-to-earnings-to-growth (PEG) ratio of 0.71. That’s actually one of the cheapest PEG ratios I’ve come across, and it suggests that Rolls-Royce is still significantly undervalued.

The bottom line

It’s not all plain sailing for Rolls. A potential pullback in consumer spending could reduce demand for air travel and thus Rolls’s income through flying hours contracts. However, there’s little evidence of this. Investors may also be wary that the engineering giant will miss out on a boom in the narrow-body jet market — Rolls left this market a decade ago.

But these are small issues. The overall outlook for Rolls-Royce is very positive, and I’m still looking at topping up my portfolio as it gains.

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.

James Fox has positions in GigaCloud Technology, Super Micro Computer, and Rolls-Royce Plc. The Motley Fool UK has recommended 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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