Rolls-Royce’s (LSE: RR) share price has risen 143% from its 14 November 12-month traded low of £2.30.
Such a rise might drive some investors to buy the stock simply for fear of missing out on further gains. Others might avoid it on the assumption that little room can be left for further stock appreciation.
As a former investment bank trader, I feel neither approach is conducive to optimising investment gains over time, in my experience. My only questions in this situation are is there any value left in a share and if so, how much?
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Is the stock still undervalued?
On the key price-to-earnings ratio (P/E) stock valuation measure Rolls-Royce trades at 19.2. This is bottom of the group of its competitors, which average a P/E of 33. So, Rolls-Royce shares are very cheap on this basis.
The same is true of the price-to-sales ratio (P/S), with the firm trading at 2.6 against its competitors’ average of 3.7.
A discounted cash flow analysis using other analysts’ figures and my own shows Rolls-Royce shares to be 52% undervalued.
Therefore, a fair price for the stock is £11.40. It may never reach that level or could go higher than this, given the vagaries of the market, of course.
But it firmly puts a price target in place that reflects the shares’ extreme undervaluation on the other measures.
Does the business outlook support more price gains?
Its H1 2024 results released on 1 August showed underlying operating profit soaring 74% to £1.149bn year on year. Free cash flow rocketed 225% to £1.158bn, and return on capital increased to 13.8% from 9%.
At the same time, Rolls-Royce dramatically increased its financial targets for this year. Underlying operating profit is expected to come in at £2.1bn-£2.3bn from the previous £1.7bn-£2bn. And free cash flow is forecast at £2.1bn-£2.2bn from the earlier £1.7bn-£1.9bn.
Further out, the firm aims for an operating profit of £2.5bn-£2.8bn by 2027 and a free cash flow of £2.8bn-£3.1bn by then. It forecasts that these numbers will give it a return on capital of 16%-18% by that point.
What are the risks?
There is always a risk with such fast growth that delivery schedules and/or product standards suffer. These are both risks for Rolls-Royce, in my opinion.
On 25 June, Airbus stated that Rolls-Royce engines for its A330neo were behind schedule. More recently, there was an in-flight failure in a Cathay Pacific A350-1000 Rolls-Royce XWB-97 engine.
If a pattern of such events becomes established then it could damage Rolls-Royce’s reputation and future profits.
Will I buy the stock?
Given its stellar growth so far and profit forecasts, I think the current price is just a stepping stone to £11+ over time.
That said, I already own another great stock in the sector (BAE Systems). As another share in the same business would unbalance my portfolio, I will not be buying.
But if I did not have BAE Systems shares, I would buy Rolls-Royce stock in a second.
