Looking at Rolls-Royce’s (LSE: RR) share price, I am reminded of a key lesson from my years as an investment bank trader.
Just because an asset has risen sharply in price does not mean it will not keep going higher.
Its steep price rise might have come from investors playing catch-up with the fair value of a company. Or the firm might just be worth more than it was before. Or it may be a combination of both.
In any event, the share may be worth a lot more than even the current elevated price implies. And this is the case with Rolls-Royce, I believe.
Can it really be undervalued?
A discounted cash flow modelling using several analysts’ figures and my own shows the company to be around 50% undervalued.
Therefore, given the current price of £4.33, this would mean a fair value for the share of £8.66.
There is no guarantee it will reach that price, of course, but it looks well-supported by key share valuation measures.
For example, on the price-to-earnings (P/E) valuation metric, Rolls-Royce trades at just 15.1.
This is the lowest in its peer group, the average P/E of which is 29.7. This comprises BAE Systems (at 22.2), General Dynamics (24.3), Northrop Grumman (32.2), and RTX (40.1).
How has it been performing?
The company’s 2023 results showed underlying operating profit up 144% — to £1.59bn from £652m in 2022.
To me, this explains much of the 178% share price gain over the past 12 months. Long-term fund managers and shorter-term traders would have been factoring in improving company performance ahead of time, in my experience.
This profit drove a 154% increase in free cash flow year on year – from £505m in 2022 to £1.85bn last year.
Over the same period, Rolls-Royce’s return on capital more than doubled – from 4.9% in 2022 to 11.3% in 2023.
Is it poised for further growth?
A risk for the company is that another pandemic would cripple its civil aerospace revenues (comprising 45% of its business). Another is that a major problem in any of its key defence sector products would be very costly to it.
However, in its December 2023 Investor Presentation, Rolls-Royce announced its intention to become a higher-value investment-grade company.
It has since achieved that, having secured investment-grade status from all three major credit ratings agencies — Standard & Poor’s, Moody’s, and Fitch.
This ratings status will give it more preferential access to capital, which can then be used to drive further growth.
To maintain this coveted ranking, Rolls-Royce has laid out key performance targets, all of which indicate significant expansion ahead.
By 2027, it intends to be generating operating profit of £2.5bn-£2.8bn, operating margin of 13%-15%, and return on capital of 16%-18%. It also aims for free cash flow of £2.8bn-£3.1bn by that time.
Will I buy it?
I have another stock in the same sector, and I am happy with that.
However, if I did not have that, there is no question I would buy Rolls-Royce today. It still looks extremely undervalued to me and looks set for stellar growth in my opinion.
