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Rolls-Royce’s (LSE: RR) share price has gained 129% from its 25 July 12-month traded low of £4.23. From its 1 July 2020 opening price of 85p five years ago it is up 1041%.
However, there is no reason why a stock cannot still have enormous value remaining even after such a rise. Value and price are not the same thing at all in share investment.
Price is simply what the market is willing to pay for a share. Value is what a stock is fundamentally worth, based on the underlying business. This includes its core financial health, competitive position, and – crucially – its earnings growth prospects.
Consequently, identifying the difference between the two in a stock can make big profits over time, in my experience.
How does the value proposition stack up?
I look at two areas when assessing how the share price-value balance of any stock is weighted.
The first of these are key share valuation ratios that I have learned to trust most over the years. These include as a senior investment bank trader and as a longtime private investor.
One of these is price-to-earnings, on which Rolls-Royce trades at 32. This is still undervalued against its competitor’s group average of 35.1. However, it has risen in the rankings recently, given its price rise.
More specifically, the rest of the group consists of Northrop Grumman at 19.4, BAE Systems at 28.9, RTX at 42.4, and TransDigm at 49.7.
Another key ratio for me is price-to-sales, on which Rolls-Royce trades at 4.3 against a peer average of 4.1. So it is now overvalued on this measure.
The other area I examine in my assessment is the fair value of the stock. This is based on cash flow forecasts for the underlying business integrated in a discounted cash flow (DCF) analysis.
Using other analysts’ figures and my own, the DCF for Rolls-Royce shows it is 11% undervalued at the current £9.70.
Therefore, its fair value is £10.90.
How does the core business look?
Rolls-Royce’s full-year 2024 numbers released on 27 February showed revenue leaping 16% year on year to £17.848bn, while operating profit soared 55% to £2.464bn. Revenue is the total income made by a firm, while profit (or ‘earnings’) is what remains after expenses have been deducted.
The firm upgraded its short- and medium-term guidance. For 2025 it expects £2.7bn-£2.9bn underlying operating profit and £2.7bn-£2.9bn free cash flow. In its 1 May trading update it reiterated these forecasts.
A risk for the firm is any major malfunction in one of its core products. This could damage its reputation and be costly to remedy.
My view
I believe Rolls-Royce is such a strong business that I bought the shares, despite also holding BAE Systems. I had to slightly adjust my entire portfolio to hold two firms in the same sector.
Crucially though, just because a business looks great, does not mean it should be bought at any price. This is where knowing how it stacks up as a value proposition comes into play. So, I would not buy the shares at the current price, as they are too close to fair value.
I will reassess whether to add to my stake as new deals and results emerge.
