When some people look at the Rolls-Royce Holdings (LSE: RR.) share price, they see a bubble waiting to burst. A stock that’s climbed more than 1,300% in five years must be overvalued, right?
Not necessarily. Despite that tremendous rise, I don’t see forecast valuations as obviously over-inflated.
I’m not saying I think the Rolls-Royce share price is going to keep on climbing at its current rate, because I don’t. I’ve said that and been wrong before, mind. But the pace surely has to slow some time, right?
Valuation check
A look at valuation forecasts shows Rolls-Royce shares on a forward price-to-earnings ratio of 43. That means it would take 43 years of earnings to cover the cost of an investment today — based on projected 2025 earnings, that is.
A P/E like that is close to three times the average for the FTSE 100. Other things equal, lower’s better. Growth investors however, are often prepared to sit on high P/E multiples for lengthy periods.
And I think Rolls-Royce is better value than that headline figure might suggest — even after its soaring price rise.
Growth and cash
For one thing, it doesn’t account for the growth I just spoke of. Analysts predict a 26% rise in earnings per share between the full-year 2024 figure and 2027. And that would drop the P/E as low as 30 by 2027 — still above average, but looking at lot better.
The headline P/E doesn’t account for cash on the books, and Rolls-Royce looks set to build that up at a fair pace. Analysts expect nearly £6.9bn net cash by the end of 2027. And if I adjust for that, it would drop that year’s mooted P/E to under 28.
It’s not a big improvement… but any earnings growth and further cash accumulation beyond that could make the Rolls-Royce share price look better value.
Great company, but at what prIce?
Billionaire investor Warren Buffett famously urged us to seek great companies at fair prices rather than fair companies at great prices. And I see a strong case for judging Rolls-Royce as a great company. That though, needs us to think about its long-term growth drivers.
I see a good base for solid future earnings streams from the company’s commanding position in the aero engine industry. It’s one of the world’s giants in a business that has a strong safety moat through huge barriers to entry.
But much of the hoped-for growth comes from prospects for small modular nuclear reactors (SMRs). And the promise there is two-fold. They’re an alternative to fossil fuels and can potentially ramp up to high capacity in a short time.
The AI angle
Then there’s the energy requirement from booming artificial intelligence (AI) demand. That has to be potentially profitable. But if an AI bubble really is set to deflate, could that affect the Rolls-Royce share price? I fear so.
I do think long-term growth investors could do well to consider Rolls-Royce even at today’s share price. But combined with the high-valuation danger, I also reckon I see lower-risk stocks at more attractive valuations that I personally prefer right now.
