Rolls-Royce shares look cheap to me after its investment-grade ratings clean sweep

Despite recent gains, Rolls-Royce shares look great value to me, as it moves into its next phase of growth spurred on by three investment-grade ratings.

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Image source: Rolls-Royce plc

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I’ve heard a lot of people recently talking about whether they should buy Rolls-Royce (LSE: RR) shares at this or that price.

As a long-term investor now, rather than the investment bank trader I was, I think this largely misses the point.

A few pennies here or there – or even a few pounds in Rolls-Royce’s case – don’t really matter if a stock’s set to make much bigger gains. And I think this company will for two key reasons.

First, its next strong phase of growth that will be powered by its new investment-grade status. And second, despite its recent huge price rise it still looks extremely undervalued against its competitors.

Investment grade is key to next growth phase

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

An investment-grade profile gives any company greater and more preferential access to capital, which can then be used to drive further growth.

Rolls-Royce knows this, which is why it committed at its Capital Markets Day on 28 November 2023 to achieving this elite profile. As part of its push to achieve this, it unveiled key financial targets to be achieved by 2027.

These are operating profit of £2.5bn-£2.8bn, operating margin of 13%-15%, and return on capital of 16%-18%. All reflect major growth in the company to that point.

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.

28 March saw major credit ratings agency Fitch upgrade Rolls-Royce to BBB-. This means that all the big three agencies — including Standard & Poor’s (S&P), and Moody’s — now rate it as investment grade.

Business already growing strongly

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

However, even before the effects of its new investment-grade status kick in, Rolls-Royce produced excellent 2023 results, in my view.

Underlying profit increased 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.

Still very undervalued

Rolls-Royce currently trades on the key price-to-earnings (P/E) stock valuation measurement at just 14. This is still by far the lowest in its peer group, despite its recent price rise.

The average P/E of these peers is 30.3. Therefore, it still looks a major bargain on this basis.

How much of a bargain? A discounted cash flow model shows Rolls-Royce shares to be around 54% undervalued at the present price of £4.03. So a fair value would be about £8.76.

This doesn’t necessarily mean it will ever reach that price. But it confirms to me that worrying about a few pennies or even pounds before buying it is short-sighted.

Will I buy it?

If I didn’t already have another excellent holding in the sector — BAE Systems – I’d buy Rolls-Royce stock now.

In my view, it’s still very undervalued when compared to other big names in its industry and it looks set for very strong growth in the coming years.

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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