The Rolls-Royce (LSE:RR) share price has gone from £1.30 to £10.64 in the last 10 years. But that doesn’t automatically mean the stock’s overvalued.
Just as shares that have gone down can be bad investments, a stock that’s gone up can still be a good one. So does Rolls-Royce still offer good value, or have investors missed the opportunity?
Discounted cash flows
One of the best ways of trying to figure out what a stock’s worth is by using a discounted cash flow (DCF) calculation. This puts a value on the cash the firm will generate in the future.
This is a good method, but it’s only as accurate as its inputs. So it depends on an investor being able to being able to anticipate how much cash a company is going to make in the future.
In the stock market, that’s never guaranteed, especially with Rolls-Royce. Disruptions to travel demand from pandemics, ash clouds, or recessions, can significantly impact profitability.
There is however, another way of trying to figure out whether or not a stock’s overvalued. It essentially reverse-engineers the DCF calculation and it’s called… a reverse DCF.
Reverse DCF
A reverse DCF doesn’t involve speculating about future cash flows. Instead, it calculates what expectations are reflected in the current share price. That can be extremely useful – investors can see whether the implied growth rate is below what they think’s likely. But there’s still an element of guesswork.
One of the inputs asks what multiple the stock’s likely to be trading at in the future? And to some extent, that’s likely to be influenced by how well the company’s doing.
With Rolls-Royce, this can be very hard to predict. But when I ran a 10-year calculation based on a 10% annual return and a future multiple of 15, I got an implied growth rate of 11.7%.
Growth
Is this achievable? My sense with Rolls-Royce is that it’s not out of the question, but I do think some pretty bullish assumptions need to be behind the idea it can grow at that rate.
The firm has clear growth potential. A shift to nuclear power in the UK, a move to sustainable aviation fuels in aircraft, and an increase in defence spending are all potential opportunities.
Nonetheless, it takes a lot to maintain an 11.7% annual growth rate for a decade. And while Rolls-Royce has managed it recently, it’s benefited from unusually strong travel demand.
I think it’s going to take a lot for the firm to keep going at that rate for another 10 years. So while it’s not the most overvalued stock on the market, I don’t see it as an obvious bargain to consider.
Valuations
The assumptions that go into a reverse DCF model can always be challenged. Some investors might think that the stock’s likely to trade at a higher multiple, or demand a higher return.
Increasing the multiple makes the implied growth rate come down and raising the required return makes it go up. But the important thing is that it’s clear what the assumptions are.
This gives investors something they can use to value other stocks. And they can see if they share my view that there are more attractive opportunities elsewhere.
