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Why Rolls-Royce Holding PLC Could Trail BAE Systems plc, Cobham plc & Meggitt plc

rollsroyce

It’s been a disappointing year for investors in Rolls-Royce (LSE: RR), with the company’s share price falling by 20% since the turn of the year. This is considerably behind the FTSE 100‘s flat performance over the same time period. Indeed, while Rolls-Royce undoubtedly has products of the highest quality and a very strong brand, it could be left behind by aerospace and defence sector peers BAE (LSE: BA), Cobham (LSE: COB) and Meggitt (LSE: MGGT). Here’s why.

Differing Valuations

Of the four companies, BAE is priced the lowest. That may be because of a profit warning earlier in the year and the expectation that 2014 is set to be a rather disappointing year for the company. However, a price to earnings (P/E) ratio of 11.7 appears to be very attractive when you consider that BAE’s sector peers trade on far higher valuations.

For example, Cobham and Meggitt have P/Es of 14.8 and 14.3 respectively: both of which appear to be attractive (although to a lesser extent than BAE). However, Rolls-Royce, despite its 20% fall over the last eight months, is by far and away the most expensive of the four sector peers. It trades on a P/E of 15.8, which is considerably higher than the FTSE 100’s P/E of 13.7, too.

Growth Potential

Furthermore, Rolls-Royce does not seem to have significantly better growth prospects than its rivals, which could have been a reason for its higher rating. The company is forecast to post a fall in earnings of 2% this year, followed by a gain of 9% next year. Certainly, these are better figures than those of BAE, which is expected to see a decline in earnings of 11% this year and a rise of 4% next year. However, BAE’s P/E is 26% lower than that of Rolls-Royce, which appears to more than adequately price in a difficult year for BAE.

Furthermore, Cobham and Meggitt seem to have similar growth potential to Rolls-Royce. For example, while Cobham is expected to post a fall in profit of 7% this year, it is expected to bounce back next year with a rise of 11%. It’s a similar story at Meggitt, where earnings are set to fall by 13% this year and grow by 10% next year. So, while all four companies are due to have a tough 2014, Meggitt and Cobham could prove to have the stronger 2015, which could act as a catalyst on their share prices.

Looking Ahead

While Rolls-Royce is undoubtedly a high-quality company, its current valuation appears to be a little rich. Certainly, there is much better value on offer at BAE Systems which, although it has more pedestrian growth prospects, still seems to be well-positioned for the long-haul. Meanwhile, Cobham and Meggitt are cheaper than Rolls-Royce and their growth profile is broadly similar to their better-known sector peer. As a result, Rolls-Royce, while an attractive long term buy, could end up trailing its sector peers over the medium term.

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Peter Stephens owns shares of BAE Systems. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.