Rolls-Royce’s (LSE: RR) share price is trading around a one-year high of just over £6. But this does not mean there is no value left in it.
Such a rise may signal that a firm is worth more now than before. Or it could be that the market is only just catching up to its true value.
Crucially, in my experience as a former investment bank trader, the higher share price might still not reflect the true worth of a firm.
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I took a close look to find out whether this is true for Rolls-Royce.
Is the stock over-, under- or fairly valued?
The first part of my process in evaluating a stock’s pricing is to compare its key valuations to those of its competitors.
On the price-to-earnings ratio, Rolls-Royce trades at 21.6 compared to its competitors’ average of 33.6. This group consists of BAE Systems at 19.8, Northrop Grumman at 29.6, RTX at 34.2, and TransDigm at 50.9. So on this measure, the aerospace, defence and power systems giant is very undervalued.
The same can be said of the price-to-sales ratio, on which it trades at 2.8 against a 3.7 average for its peers.
I ran a discounted cash flow (DCF) analysis to cut to the chase in this pricing assessment. This indicates where a stock price should be, based on future cash flow forecasts.
Using other analysts’ figures and my own, this shows Rolls-Royce shares are 38% undervalued at their price of £6.05. So a fair value for them is technically £9.76.
This leaves them looking a huge bargain to me, although there is no guarantee that they will reach that price any time soon.
Major new deals coming in
The firm has won three major orders in less than a month.
On 9 January it signed an agreement with Polat Enerji for Turkey’s largest energy storage deal.
Then it won an order for 10 Trent XWB–97 Engines from STARLUX Airlines. December had already seen EuroJet Turbo agree to provide 59 new EJ200 engines for the Spanish Air Force. This engine is a collaboration between Rolls-Royce, MTU Aero Engines, ITP Aero and Avio Aero.
And on Friday (24 January), the UK’s Ministry of Defence awarded a £9bn contract for its nuclear submarine fleet to the firm.
How do the finances look?
Even before these new deals, Rolls-Royce had already significantly upgraded its 2024 guidance. In its 1 August H1 2024 results, the underlying 2024 operating profit forecast was increased to £2.1bn-£2.3bn from £1.7bn-£2bn. And the free cash flow forecast was raised to £2.1bn-£2.2bn from £1.7bn-£1.9bn.
A principal risk to these in my view is that production capacity fails to keep up with such sales growth. Any enduring delays in customer deliveries could damage the firm’s reputation and profits over time.
That said, Rolls-Royce projects £2.5bn-£2.8bn in operating profit and £2.8bn-£3.1bn in free cash flow by 2027.
Will I buy the stock?
I already hold BAE Systems’ shares and adding another stock in the sector would unbalance my portfolio’s risk-reward balance.
However, if I did not have this, I would buy Rolls-Royce shares today without a moment’s hesitation. It looks set for stellar growth over time, which should push its share price much higher, in my view.
