The Rolls-Royce (LSE:RR) share price has surprised thousands of investors. It has continually gone from strength to strength since late 2022, surging by over 600%.
Currently, I appreciate many investors think the stock is vastly overvalued. In fact, I’ve seen several colleagues suggest the stock is too expensive simply because of its price-to-earnings (P/E) ratio.
However, I believe they’re underestimating Rolls-Royce. And some of the biggest and best financial institutions around the world agree with me.
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On Wall Street, the average price target for Rolls-Royce shares, issued in the past three months, is 535.52p, representing a 13.4% premium to the current share price.
In other words, Wall Street analysts think the British engineering giant is undervalued by 13.4%.
For further context, all eight of the Wall Street analysts covering the stock in the last three months say Rolls-Royce stock is a ‘buy’. And the most recent ratings are among the most bullish.
The last three share price targets issued were Citi (555p), Goldman Sachs (545p), and UBS (550p).
Why is this?
Why are analysts still bullish on Rolls-Royce?
Well, it’s all mostly about under-appreciated cash flow and growth.
For instance, according to Goldman Sachs, Rolls-Royce could deliver £2.3bn of operating profit and £2.4bn of free cash flow in 2024 — that’s above the company’s own forecasts.
Victor Allard, the Goldman Sachs analyst covering Rolls, suggests better-than-expected earnings will act as another catalyst for the stock.
The other aspect is growth. Rolls-Royce is trading at 30 times forward earnings, which isn’t palatable for all UK investors.
However, analysts suggest that earnings will grow by around 28% annually over the next three to five years.
In turn, this gives us a price-to-earnings growth ratio of 1.07. That’s an appealing number.
Risk and reward
Like all investors, I’ve invested in booming stocks only for them to slump. This pain can really impact our future investment decisions.
So, I can understand why some investors may be concerned about investing in a stock that has surged 202% over 12 months. This surge also means there’s going to be a degree of profit-taking, and arguably this represents one of the biggest risks right now.
It’s also the case that forecasts can be wrong, and that’s something all investors need to be wary of.
However, that’s a near-term concern, and the bottom line is all three of Rolls-Royce’s business segments are booming, and are forecasted to stay that way.
Civil aerospace, the company’s biggest business segment, is resurgent. The company says that engine flying hours — Rolls earns as its engines are used — could reach 110% of 2019 levels this year.
Defence is performing well on the back of governments around the world committing to new long-term defence programs. And power systems remain a resilient part of the business.
More broadly, everything is moving in the right direction. The operating margin rose to 10.3% in 2023, more than double the 5.1% in 2022, and management is aiming for 13%-15% by 2027.
In short, I think there’s very little holding the business back.
