Rolls-Royce’s (LSE: RR) share price is now trading near a 12-month high, following a dip at the beginning of September to £4.56.
This came after the in-flight failure on 30 August of a part in a Cathay Pacific A350-1000 Rolls-Royce XWB-97 engine.
However, the European Union Aviation Safety Agency (EASA) said on 19 September that the failure may not have been a structural flaw in the engine nozzle. It may instead have been due to a process used to clean the fuel hose.
How do the growth prospects look?
The day before the EASA statement, Rolls-Royce announced a landmark achievement for its Small Modular Reactor (SMR) unit. The Czech Republic’s state utility ČEZ Group selected it as the preferred supplier for its mini-nuclear reactor programme.
On 24 September, the UK government also announced that it has shortlisted Rolls-Royce as one of four companies for its own SMR initiative. Two firms will ultimately be chosen to implement the project.
Industry forecasts are for the global SMR market to reach $72.4bn by 2033 and $295bn by 2043. This represents a compound annual growth rate of 30% during this period.
A principal risk for Rolls-Royce is a major failure in any of its key products, which would be costly to remedy.
However, as it stands, it aims for an operating profit of £2.5bn-£2.8bn by 2027 on an operating margin of 13%-15%. It also targets a return on capital of 16%-18% and free cash flow of £2.8bn-£3.1bn by then.
How undervalued are the shares?
My usual starting point for assessing what the shares are worth is to look at key relative stock valuation measures, beginning with the price-to-earnings ratio (P/E).
Rolls-Royce currently trades at a P/E of 19.2 – bottom of its group of competitors, with an average P/E of 44.4.
So, the stock looks very cheap on this basis, despite its price rise over the past year and more.
The same is true on the price-to-sales ratio (P/S) as well. Rolls-Royce presently trades at a P/S of 2.5, against a competitor average of 3.9.
To put this into cold, hard cash terms I ran a discounted cash flow analysis using other analysts’ figures and my own.
This shows Rolls-Royce shares to be 54% undervalued at their present price of £5.28. So, a fair value for them is £11.48, although they may go lower or higher than that.
Therefore, anywhere under this price looks cheap to me.
Will I buy the stock?
I already own shares in another company in the same sector (BAE Systems), so buying another similar holding would unbalance my portfolio.
I have also focused on stocks that pay a very high yield since turning 50 a few years ago. BAE Systems is just one of a handful of growth stocks that I held before then that I have kept.
That said, if I were at an earlier point in my investment cycle, I would buy Rolls-Royce shares right now.
One reason is that they are still extremely underpriced relative to their competitors’ stock. They also look undervalued compared to the firm’s likely future cash flow generation.
Another is that the firm’s long-term earnings prospects also look excellent to me, enhanced by new projects such as in the nuclear sector.
