Is the Rolls-Royce share price simply a joke?

The Rolls-Royce share price has extended its gains over the past 12 months — it’s now up 186%. Has the bull run simply gone too far?

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Many novice investors may be wondering what to make of the Rolls-Royce (LSE:RR) share price. And I appreciate it can be challenging given the wide variety of commentaries on offer. While I’ve remained largely bullish on the British engineering giant, I appreciate many of my colleagues at the Motley Fool have been more cautious.

Is the share price a joke?

Has the rising value of Rolls-Royce shares become a joke? Simply, no. The engineering giant isn’t clearly undervalued, as it was a year ago, and now there’s healthy debate as to whether the company represents good value to investors.

The consensus of analysts covering the stock highlights this. There are currently eight ‘buy’ ratings, four ‘outperform’ ratings, four ‘hold’ ratings, and one ‘sell’ rating.

However, the average share price target is just 3.8% above the current share price. If we assume the average share price target represents fair value for the stock, that doesn’t leave us with much margin for safety.

Nonetheless, I’d caution that analysts, even City and Wall Street institutions, don’t update their share price targets that often. These targets can become quickly outdated, especially if we’re looking at stocks that are gaining quickly.

How could the shares still be undervalued?

Rolls-Royce stock was “woefully mispriced” 18 months ago, and sentiment has since improved. In addition to improving sentiment, the civil aerospace, defence, and power systems manufacturer has continually outperformed expectations quarter after quarter.

Moreover, the company’s forward guidance has kept improving, and we’re now in a position where the expected earnings are very strong, even given the current share price. Here’s a table showing expected earnings and the associated price-to-earnings (P/E) ratios.

Earnings per share (p)Price-to-earnings

But isn’t this expensive?

The average P/E ratio for the FTSE 100 is around 11 times. So, Rolls-Royce shares are considerably more expensive than the index average on a near-term basis. Sadly, I’ve seen some people note this as a reason not to buy the stock.

However, in reality, it shouldn’t be that straightforward. All stocks offer something different, and Rolls-Royce offers much stronger earnings growth than the FTSE 100 average. In fact, analysts suggest that Rolls-Royce’s earnings will grow by around 28.5% annually over the medium term.

So, would I rather pay 11 times earnings for companies with very little earnings growth prospects, or 28.7 times earnings for a stock that is expected to grow all parts of its business? I’d still rather buy Rolls-Royce shares.

This is also a good opportunity to point out that the price-to-earnings growth (PEG) ratio sits around one. Some analysts with stronger earnings expectations put the PEG ratio lower (that’s better) and others have it a little higher.

Nonetheless, a PEG ratio around one in the current market is still very attractive.

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 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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