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Rolls-Royce shares: why I’d invest £1,000 today

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What a week it was. The Rolls-Royce Holdings (LSE: RR) share price rose by around 25%, while the FTSE 100 gained more than 7% to end the week around 6,300.

The trigger for this surge was the news that US pharma giant Pfizer believes it has developed a Covid-19 vaccine that’s more than 90% effective. Production is already said to be under way, stockpiling doses ahead of regulatory approval.

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In my last piece on Rolls in October, I said I’d revisit the stock in November. Today I want to explain why I’m increasingly bullish about Rolls-Royce shares, despite their rising price tag.

A rapid recovery?

The UK government has 40m doses of the Pfizer vaccine on order. Other western countries have made similar provision. The first deliveries could be made before the end of the year, assuming the vaccine is approved by regulators.

Bullish investors now seem to be betting that the world could go back to normal quite quickly. If this view is accurate, then I think Rolls-Royce’s recovery might also come sooner than we were expecting.

Airlines operating international routes have largely been grounded by travel bans, quarantine rules and passenger anxiety. British Airways owner IAG plans to fly just 30% of its 2019 capacity in the final quarter of 2020, for example. When airlines aren’t flying, jet engines don’t need servicing. That’s bad for Rolls-Royce’s civil aerospace division, which makes most of its profit from servicing and maintenance.

However, I’d guess that a rapid rollout of a vaccine over the next six months could see airlines operating as normal by next summer. This should result in rising revenue for Rolls-Royce.

The Rolls-Royce share price has doubled: is it still cheap?

Rolls-Royce shares were trading at under 70p a week ago. Is it worth paying 25% more for the same stock today?

I think it could be. My approach to share price action is that it’s largely irrelevant when buying and selling shares. What matters to me is valuation. Either a stock offers good value, or it doesn’t.

To try and work out whether Rolls-Royce shares still look affordable, I’ve used the latest guidance provided by the company on future cash flows.

CEO Warren East is targeting annual free cash flow of at least £750m in 2022. My sums show that hitting this £750m target would give free cash flow per share of about 9p. At a share price of 90p, that would value Rolls-Royce shares at around 10 times free cash flow.

I’d consider this to be good value, although it’s worth remembering that this is a forecast for 2022. Right now, the company is still losing money.

Why I’d buy Rolls-Royce shares today

Even before last week’s vaccine news, my view was that the world would gradually return to normal over the next year or two. Airline passenger numbers might take a while to recover, but fundamentally these businesses would return to normal operation.

My view now is that we could see something like normality by next summer. That being so, I think Rolls-Royce shares probably offer decent value at current levels, on a long-term view. I’d be happy to buy the shares for my ISA portfolio at current levels, even though I’ve missed the recent lows.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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