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Play The Percentages With Rolls-Royce Holding PLC

The forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.

However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).

EPS spread Bull extreme P/E Consensus P/E Bear extreme P/E
Narrow 10% (+ and – 5%) 13.3 14.0 14.7
Average 40% (+ and – 20%) 11.7 14.0 17.5
Wide 100% (+ and – 50%) 9.3 14.0 28.0

In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the consensus 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!

Rolls-Royce

Today, I’m analysing British aerospace icon Rolls-Royce (LSE: RR), the data for which is summarised in the table below.

Share price 1,040p Forecast EPS +/- consensus P/E
Consensus 68.1p n/a 15.3
Bull extreme 75.3p +11% 13.8
Bear extreme 57.3p -16% 18.2

As you can see, with the most bullish EPS forecast 11% higher than the consensus, and the most bearish 16% lower, the 27% spread is narrower than the 40% spread of the average blue-chip company. It is also a little narrower than Footsie peer BAE Systems.

Rolls-RoyceBig contracts are a feature of Rolls-Royce’s industry. While there’s a certain lumpiness to the winning of such contracts, once they’re in the bag there’s generally good visibility on how the cash will flow from them over their lifetime (many years in some cases).

This core of predictability makes for a tighter range of plausible earnings scenarios than we see for many industries — including some of those where Rolls-Royce’s products end up: International Consolidated Airlines (formed by the merger of British Airways and Spanish flag carrier Iberia), for example, currently has an EPS spread of 60%.

While Rolls-Royce’s spread is comparatively tight, only the bull extreme EPS forecast gives a P/E below — negligibly below — the FTSE 100 long-term average of 14, with the consensus at 15.3 and the bear case giving a reading of 18.2.

Nevertheless, even though Rolls-Royce is on the expensive side, it has been rated more highly than today in the recent past. The shares took a big hit in January when the company said: “In 2014, we expect a pause in our revenue and profit growth”.

Management stressed: “This is a pause, not a change in direction, and growth will resume in 2015”, adding that “our record order book underpins our confidence in the long-term growth of our business”, but the market — which includes, of course, short-sighted traders — didn’t like it.

As such, I think this quality company may currently represent reasonable value for long-term investors, despite the P/E being at a bit of a premium to the wider market.

Rolls-Royce isn't the only quality business in the FTSE 100. In fact, it didn't quite make the cut when the Motley Fool's leading analysts set out to identify Britain's five best blue chips.

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G A Chester does not own any shares mentioned in this article.