Rolls-Royce’s (LSE: RR) share price has dropped around 11% from its 1 August 12-month traded high of £5.02. That was also the day its H1 2024 results were released.
Part of the reason for this was the broader fall in the FTSE 100. This aligns with similar drops in other major global indices on growing fears of a recession in the US.
Before this the stock had declined on what I surmise is investors thinking there is little value left in it.
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It is an understandable view, as the shares have risen 127% from their 23 October 12-month traded low of £1.97.
However, it is crucial to remember that a stock may still have substantial value left in it even after a major price rise. This applies to Rolls-Royce, in my view.
Still significantly undervalued?
The shares currently trade at just 16.8 on the key price-to-earnings (P/E) stock valuation measurement.
This is the lowest such valuation among its competitors, the average P/E of which is 34. These comprise BAE Systems at 20.9, Northrop Grumman at 31.6, L3Harris Technologies at 36.7, and TransDigm Group at 46.8.
So, Rolls-Royce shares look very cheap on this basis.
But how much of a bargain is it in cash terms? A discounted cash flow analysis shows the stock to be 59% undervalued at the present price of £4.47.
Therefore, a fair price for the stock would be £10.90. It might go lower or higher than that, but it underlines to me how cheap it looks.
Strong growth outlook?
Rolls-Royce’s H1 2024 results showed revenue rising 18% to £8.182bn, from £6.95bn in H1 2023. Underlying operating profit jumped 74% to £1.149bn from £0.673bn, and operating margin increased to 14% from 9.7%.
Over the same period, free cash flow soared 225% to £1.158bn from £0.356bn, and return on capital increased to 13.8% from 9%.
As a result of these startling gains, the firm raised its guidance for full-year 2024 to £2.1bn-£2.3bn underlying profit, from £1.7bn-£2bn. It did the same for its free cash flow guidance, increasing it to £2.1bn-£2.2bn from £1.7bn-£1.9bn.
A risk in such growth for the firm is that the delivery schedule and/or quality of its products suffers. This could damage its reputation over time and eventually impact sales.
That said, the business is still targeting an underlying operating profit of £2.5bn-£2.8bn, and an operating margin of 13%-15% by 2027. It is also aiming for a free cash flow of £2.8bn-£3.1bn and a return on capital of 16%-18% by that time.
Should I buy the shares?
I already hold another stock in the sector – BAE Systems — bought at a much lower price than it is now. Buying another would unbalance my portfolio.
However, if I did not have this, I would buy Rolls-Royce shares today. The stock still looks to be packed with value, which should drive the share price higher, in my view. This is likely to be further enhanced by the extremely strong projected growth in the coming years.
Such expansion should also gradually drive up the dividend that Rolls-Royce reinstated in the H1 results announcement, I think.
