Play The Percentages With Rolls-Royce Holding PLC

How reliable are earnings forecasts for Rolls-Royce Holding PLC (LON:RR) — and is the stock attractively priced right now?

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

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.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »