The Rolls-Royce (LSE:RR) share price continued growing through 2024, delivering 100% growth over 12 months. As the company continues its transformation under CEO Tufan Erginbilgiç, analysts are optimistic about its prospects, citing strong earnings growth and improved profitability. In fact, from its low point around 26 months ago, it’s hard to imagine how things could have gone better.
However, challenges such as high valuation metrics and market volatility could temper expectations. With key factors like travel demand and defence spending playing crucial roles, the outlook for Rolls-Royce remains intriguing as investors weigh the possibilities of sustained momentum against potential valuation concerns.
Valuation concerns might not be justified
Concerns about Rolls-Royce’s valuation might not be justified. While the company trades ahead of its long-term EV-to-EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortisation) ratio, this metric has been historically low due to past issues, including efficiency and the pandemic.
Rolls-Royce has emerged from recent challenges more cost-efficient and significantly deleveraged — having an improving debt position — with strong prospects in its end markets. The company’s successful turnaround and growth potential support a positive outlook among management and with analysts projecting continued strong EBITDA growth through 2026.
In other words, the company’s foundations are strong and the business is growing. Free cash flow is also expected to continuing growing, albeit at a slower rate than over the last year due to higher capital expenditure for long-term growth positioning.
Growth comes at a premium
As investors, we’re typically willing to pay a premium for companies that promise to grow earnings. Sometimes, that premium can be a little extreme — Arm Holdings, Broadcom, and Tesla could be examples of where the growth premium is simply too high.
However, Rolls-Royce’s growth-oriented metrics are much more palatable. The stock is currently trading at 35 times forward earnings, but the company is expected to grow earnings annually by 30% over the medium term. This gives us a price-to-earnings-to-growth (PEG) ratio of 1.18.
This PEG ratio might be above the traditional fair value benchmark of one, but valuation metrics are always relative. It’s cheaper than peers, and Rolls operates in sectors with very higher barriers to entry.
Given these factors, a peer group valuation suggests the stock is trading between 30% and 50% below its competitors based on forecasted earnings for the next two years. This indicates that current valuation concerns may be overstated, considering Rolls-Royce’s improved fundamentals and future growth platforms.
The bottom line
Investors should be cautious about Rolls-Royce due to ongoing aerospace supply chain challenges that affect working capital efficiency, output, and new airplane deliveries. These issues can potentially reduce engine flying hours and impact the company’s long-term services agreement business.
Despite this, management and analysts remain confident in the company’s ability to continue delivering growth and value for investors. If the company continue to exceed quarterly growth expectations, I’d thoroughly expect it to push higher. If I didn’t already have healthy exposure to this engineering giant, I’d consider buying more.
