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Are you tempted by the 20% fall in the Rolls-Royce share price? Here’s what you need to know

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One of the casualties of the recent market sell-off is FTSE 100 engineering group Rolls-Royce Holding (LSE: RR). The jet engine maker’s share price has fallen by more than 20% from August’s 52-week high of 1,104p.

If you’re bullish about the outlook for Rolls-Royce, then this should be good news. You can now buy shares in the same business for 20% less than in August.

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Buying at today’s lower price means you’ll get more of the company’s future earnings for each £1 you invest. That means a higher dividend yield and — hopefully — bigger capital gains.

What I’d do

Rolls-Royce’s half-year results showed the group moving back into the black, with an underlying operating profit of £141m on revenue of £7,040m. That only implies an operating margin of 2%, but performance is expected to improve in the second half. Rolls expects to report a full-year operating profit figure of £400m-£500m.

Better still is that chief executive Warren East expects this to be backed by underlying free cash flow of £450m-£550m. That’s good news — cash generation is the ultimate test of any business, in my opinion.

I’m fairly confident of Rolls’ long-term future. What I’ve found harder to understand is how this stock should be valued. It’s a complicated business and makes much of its money from after-sales services, rather than directly from engine sales.

The clarity of the group’s accounting and guidance has improved greatly since Mr East took charge. Based on his track record so far, I’m increasingly happy to rely on the firm’s guidance.

Mr East’s target is to generate £1bn of free cash flow per year by 2020. Looking beyond that, he has a “mid-term ambition” to generate free cash flow of more than £1 per share.

At current levels, these targets put the stock on a 2020 forecast price/free cash flow ratio of 16 and a “mid-term” forecast P/FCF ratio of about 8.7. These figures suggest to me that Rolls-Royce stock could offer good value to long-term investors at current levels.

Better than expected

One of Tuesday’s top risers was FTSE 250 engineering group Meggitt (LSE: MGGT). Shares in the Dorset-based group were up by 6% at the time of writing after it said that sales growth would be stronger than expected this year.

Strong demand for new parts and after-market services from civil aerospace customers and defence clients mean that the company expects to report organic sales growth of 7%-8% for 2018, up from previous guidance of 4%-6%.

Profit outlook improved?

Today’s update didn’t provide any update on profit guidance. But Meggitt did say that its guidance for operating profit margins is expected to be towards the lower end of 17.7%-18%.

This is consistent with previous guidance, so I’d guess that the increase in revenue could mean that profits will be slightly ahead of current market forecasts for earnings of 32.9p per share.

I estimate that Meggitt shares trade on a 2018 forecast price/earnings ratio of 15 after today’s news, with an expected dividend yield of about 3.3%. This looks fair value to me, but the group’s improving performance suggests the stock could continue to climb. Like Rolls-Royce, I see Meggitt as a long-term buy-and-hold stock.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Meggitt. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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