Even around £4.60, Rolls-Royce shares still look extremely undervalued to me

Despite their stellar price rise, Royce-Royce shares are still undervalued on key metrics and could go much higher on continued strong performance.

| More on:

Image source: Rolls-Royce plc

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Rolls-Royce (LSE: RR) shares have risen over 200% over the past 12 months, leaving many investors in a quandary.

For some, such a move signals that they should jump on the bandwagon, or they will miss out. For others, it cautions that they should avoid the shares, as they are too expensive.

In my experience as a former investment bank trader, neither view is conducive to making big, long-term investment returns.

The only question that should be asked in my view is whether there is value left in the shares. If there is, then they may well be worth buying, depending on the circumstances of the investor.

Still undervalued?

Despite the recent price rise, Rolls-Royce shares currently trade at just 15.8 on the key price-to-earnings (P/E) stock valuation measurement.

Compared to their peer average P/E of 29.6, they look very undervalued.

But by how much precisely? A discounted cash flow analysis shows the shares to be 48% undervalued at the present price of £4.62. So a fair value for the stock would be about £8.88.

There is no guarantee they will reach that point, but it highlights just how undervalued they still look. 

This seems even more the case to me, given the company’s stellar results in 2023.

Its underlying operating profit increased 144% to £1.59bn from £652m in 2022. Its free cash flow soared 154% to £1.85bn. And its return on capital more than doubled from 4.9% to 11.3%.

Next catalysts for share price gains?

A risk for the company is that another pandemic (or other big crisis) would cripple its civil aerospace revenues (comprising 45% of its business). A major problem in its key defence sector products would also be very costly to it.

However, back in December, it laid out key performance forecasts to 2027. These included an operating profit of £2.5bn-£2.8bn, an operating margin of 13%-15%, and a return on capital of 16%-18%. It also aims for free cash flow of £2.8bn-£3.1bn by that time.

On 23 May, it stated that this year alone underlying operating profit could increase by as much as 25% — to £1.7bn-£2bn.

It also said that its civil aerospace unit could finish this year at up to 110% of its pre-Covid flying hours.

It additionally underlined the importance of its recently achieving the coveted investment-grade status from the three major credit ratings agencies. This will give it more preferential access to capital, which can then be used to drive further growth.

Will I buy it?

I already own shares in BAE Systems, which operates in the same sector, so adding another would unbalance my portfolio.

Additionally, having turned 50 a while ago, I am focused on companies that pay dividends. Rolls-Royce currently does not. However, it has indicated it will do so in the future, as part of its new investment-grade company status.

This said, if I was even 10 years younger, and without other similar holdings, I would buy the stock now.

It has great growth prospects and is still highly undervalued, in my view.

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.

More on Investing Articles

A pastel colored growing graph with rising rocket.
Investing Articles

With the FTSE 100 flying, I love the look of this company

The FTSE 100 index has been in rally mode over the last few months, but I think one of it's…

Read more »

Investing Articles

17% of my Stocks and Shares ISA is invested in these 2 UK shares

Stephen Wright looks to focus on investments in companies that have strong competitive advantages. And two UK shares stand out…

Read more »

Investing Articles

Here’s how much income I’d get if I invested my entire £20k ISA into Lloyds shares

Harvey Jones bought Lloyds shares last year and is kicking himself for failing to buy even more of them. The…

Read more »

Smiling white woman holding iPhone with Airpods in ear
Investing Articles

Apple is still my favourite company in the S&P 500, here’s why

Apple recently unveiled a lot of new software at a developer conference. Here's why the tech giant is still my…

Read more »

Investing Articles

5 great value UK companies I’d buy in a Stocks and Shares ISA and aim to hold for decades 

Harvey Jones is getting to work on his Stocks and Shares ISA. He thinks these five firms have solid income…

Read more »

Value Shares

Are GSK shares a bargain after falling 11%?

GSK shares have taken a hit in recent weeks due to Zantac uncertainty. Here, Edward Sheldon looks at whether they’re…

Read more »

Investing Articles

Nearing £5, could the Rolls-Royce share price hit £6?

The Rolls-Royce share price has soared in the past year. Our writer thinks there could be a strong runway ahead…

Read more »

Warren Buffett at a Berkshire Hathaway AGM
Investing Articles

Here’s how I’d aim to build wealth the same way as Warren Buffett

Christopher Ruane looks at some of the principles used by billionaire investor Warren Buffett and explains why he also uses…

Read more »