Image source: Rolls-Royce plc
Some investors may think the 98% one-year rise in Rolls-Royce’s (LSE: RR) share price is reason to avoid the stock.
Others may believe they should jump on the bandwagon to avoid missing out on further gains.
As a former senior investment bank trader and longtime private investor, I know neither view is conducive to making consistent investment gains.
I am only concerned whether the share has value left in it. If there is and it suits my portfolio objectives, then I will buy it.
Determining the fair value of the stock
To assess the value remaining in any share I begin by comparing its key valuations to its competitors.
Rolls-Royce currently trades at a price-to-earnings (P/E) ratio of 22.2. This is in the middle of its peer group, which comprises Northrup Grumman at 16.5, BAE Systems at 19.1, RTX at 35.8, and TransDigm at 45.6.
Nonetheless, it is undervalued against this group’s average P/E of 29.2.
The same is true of its 2.9 price-to-sales ratio compared to a 3.6 competitor average.
To get to the bottom of its valuation, I ran a discounted cash flow (DCF) analysis. This shows where any stock should be priced, based on future cash flow forecasts for a firm.
Using other analysts’ figures and my own, the DCF shows Rolls-Royce is 32% undervalued at £6.34.
So, the fair value of the shares is technically £9.32, although market forces may push them lower or higher.
Does the business look strong?
I think the principal risk to Rolls-Royce is that its production capabilities cannot keep pace with demand for its products.
Any significant slippage in the reliability of its deliveries could incur heavy costs to remedy and could damage its reputation.
Recent months have certainly seen a flood of new orders. The most recent of these was the 24 January £9bn contract award for the UK’s nuclear submarine fleet.
On 6 February, the UK promised to free more sites for nuclear energy developments across England and Wales. This is part of its push to expand the use of Small Modular Reactors (SMRs) to decarbonise the power network.
Rolls-Royce is one of four bidders for contracts that are likely to be worth billions of pounds. Two firms will ultimately be chosen to implement the SMR projects.
Industry forecasts are for the global SMR market to reach $72.4bn by 2033 and $295bn by 2043.
How have its recent results been?
Rolls-Royce’s H1 2024 results saw revenue jump 18% year on year to £8.182bn. Underlying operating profit soared 74% to £1.149bn, and operating margin increased to 14% from 9.7%.
Free cash flow (FCF) rocketed 225% to £1.158bn and return on capital increased to 13.8% from 9%.
Given these stellar figures, the firm upgraded its guidance for full-year 2024 to £2.1bn-£2.3bn underlying profit, from £1.7bn-£2bn. It raised its FCF guidance to £2.1bn-£2.2bn from £1.7bn-£1.9bn.
Will I buy the stock?
I already have shares in BAE Systems. Any additional holdings in the sector would negatively the risk/reward balance of my overall portfolio.
However, if I did not have this holding then I would buy Rolls-Royce stock as quickly as possible. As it stands, I feel it is worth investors considering.
I believe it will reach its strong growth forecasts, which should push the share price higher over time.
