Are Rolls-Royce shares undervalued heading into 2025?

As the new year approaches, Rolls-Royce shares are the top holding of a US fund recommended by Warren Buffett. But is there still a buying opportunity?

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It isn’t often a UK stock appears on a US company’s investment list. But as 2025 approaches, Rolls-Royce (LSE:RR) shares are top of one firm’s portfolio – and it’s not just any US company.

It’s the Sequoia Fund. I don’t spend much time looking at what other investors are doing as a rule, but there are a few exceptions – and this is one of them. 

Buffett’s only recommendation

In 1969, Warren Buffett decided he couldn’t see attractive investment opportunities in the stock market. So he made his one-and-only recommendation for investors: the Sequoia Fund.

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At the time, this was run by Bill Ruane. Not to be confused with Sequoia Capital – a venture capital operation – the firm was focused on principles that align with Buffett’s own and remains that way today. 

These include thinking like the owner of a business and buying shares in companies to hold for the long term. And since the fund began, this strategy has outperformed the S&P 500 by more than 2% a year.

Heading into 2025, Rolls-Royce shares are the company’s largest holding, accounting for around 10% of its overall portfolio. I think that’s something worth paying attention to.

Growth sources

Over the last couple of years, Rolls-Royce shares have primarily been driven by a recovery in the number of flying hours. But even with this stabilising, Sequoia sees longer-term opportunities ahead.

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In a letter from this year, the firm identified two major sources of growth for Rolls-Royce. The first is engine innovation in its civil aerospace division, which is around 50% of total revenues.

The second is new contract wins in the defence segment. While the payoff for these is further in the future, Sequoia’s anticipating significant returns starting at the end of the decade.

These are ongoing long-term sources of growth that explain why the fund hasn’t been selling its stake in Rolls-Royce. But it also hasn’t been adding to its investment. 

Valuation

Sequoia’s investor letter from this year said the following:

“When we consider near-term business growth, the £1.5 billion or so likely to be realized via non-core asset sales, and the working capital efficiencies that Erginbilgiç and his team are working to unlock, we figure that the company is likely to generate free cash flow over the next four years amounting to upwards of half its current market capitalization”.

That’s clearly an attractive proposition, but the Rolls-Royce share price was £3.01 at the time the letter was released. It’s around £5.75, as I write this, which changes the equation a bit.

Even if all of the anticipated cash is still to be returned, this now accounts for around 26% of the current market-cap. Over the next three years, that’s still a very good return, but it’s much less than it was.

There are also clear risks. Anything that disrupts flying hours – such as a pandemic, an Icelandic ash cloud, or a recession – has a big impact on the firm’s profits and the rewards on offer need to justify this.

I’m not buying

Sequoia’s neither buying nor selling Rolls-Royce shares right now. And I’m not buying either. While I thought the stock was significantly undervalued at the start of this year, I’m not so sure going into 2025.

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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.

Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has recommended 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.

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