Image source: Rolls-Royce plc
Rolls-Royce’s (LSE: RR) share price has more than doubled from its 25 July 12-month low of £4.23.
Such a price rise raises the natural question for investors of whether it can go any higher?
As a former investment bank trader and longtime private investor, I believe the answer to this depends on another question. And this is whether there is any value left in the stock.
Value is not the same as price, despite the two often being used synonymously. And it is in the difference between them that big, long-term profits can be made, in my experience.
How much value is left in the shares?
The first part of my assessment on any stock is to compare its key valuations with those of its competitors.
Despite its share price surge, Rolls-Royce’s 28.2 price-to-earnings ratio is the second lowest among its peers. These average a ratio of 33.5 (although one of them is much lower), and comprise Northrop Grumman at 18.4, BAE Systems at 29.1, RTX at 39, and TransDigm at 47.5.
So, Rolls-Royce is still undervalued on this measure.
On the price-to-sales ratio, it is also undervalued – albeit only slightly – at 3.8 against a competitor average of 3.9.
The second part of my stock assessment process is to run a discounted cash flow (DCF) analysis. This pinpoints where any firm’s share price should be, based on future cash flow forecasts for the business.
Using other analysts’ figures and my own, the DCF for Rolls-Royce shows its shares are 24% undervalued at the current price of £8.61.
Therefore, their fair value is £11.33. Of course, they may never reach that price but in the right circumstances they could also soar far beyond it.
How does the core business look?
A risk to the business is any failure in one of its core products. This could be costly to fix and could damage its reputation. Another could be a sustained global economic slowdown hitting demand for its aerospace engines.
That said, in its 1 May trading update it reiterated its 2025 guidance of £2.7bn-£2.9bn in underlying operating profit and the same in free cash flow.
It also highlighted several major developments from the previous month. One was the delivery of its first AE 3007N engine to Boeing for the US Navy’s aircraft carrier-based drone programme.
Another was the certification of its new Trent XWB-84 EP engine variant in the Airbus A350-900.
A week later Rolls-Royce was awarded a five-year support contract by the UK’s Ministry of Defence. This is for the maintenance and service of the EJ200 engine that powers the Royal Air Force’s Typhoon aircraft.
Will I buy more?
For a long time, I held off buying Rolls-Royce shares because I already owned another stock in the same sector – BAE Systems. Buying another would have unbalanced the risk-reward balance of my overall portfolio.
However, after a reweighting of my stock holdings in recent weeks, I finally bought Rolls-Royce shares.
I did so because the firm looked set for extremely strong growth to me from that point. I believed this would power the share price and dividends higher over the long term.
Nothing has changed in this regard, and the stock still looks undervalued to me. Consequently, I will buy more very soon.
