The Rolls-Royce (LSE: RR) share price has surged almost threefold over the past 12 months. This raises two key questions for me, as for other investors, I imagine, who also do not hold the stock.
First, can there be any value left in the shares after such a dramatic price rise? Second, even if there is, can I bring myself to buy them at such an elevated level?
Any value left?
Just because a stock has risen sharply in price does not mean it is overvalued. It may simply be that the company is worth more now than it was before. In fact, it could well be worth even more than the current share price reflects.
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To find out whether this is true for Rolls-Royce, I looked at the key price-to-earnings (P/E) ratio measurement.
It trades at a P/E of 15.5 – surprisingly to many, perhaps, the lowest in its peer group. This group comprises other major companies involved in civil and defence aerospace, and in developing and manufacturing power systems.
BAE Systems trades at a P/E of 18.2, Honeywell International at 24.6, RTX Corporation at 40.6, and Babcock International at 69.7.
Against the peer group average of 38, Rolls-Royce’s 15.5 looks very undervalued.
Core business look strong
Its core business also looks to be on an uptrend. H1 2023 results showed an underlying revenue rise to £6.96bn (from £5.3bn in H1 2022).
Underlying operating profit also increased — to £673m in the period (from £125m in H1 2022). And the underlying basic earnings per share (EPS) jumped to 4.9p (from a loss of 2.24p in H1 2022).
In December 2023 it unveiled financial targets to be achieved by 2027. These include £2.5bn-£2.8bn in operating profit, a 13%-15% operating margin, and a 16%-18% return on capital.
Additionally, it is aiming for free cash flow of £2.8bn-£3.1bn by that time. This cash pile can provide another major boost to growth.
This said, there are risks in the stock. Civil aerospace constitutes around 43% of all Rolls-Royce’s business, so a new pandemic would cripple its revenues in the sector. Additionally, a major problem in any of its key defence sector products would be very costly to it.
Do I buy or not?
Neither these risks nor the high share price are deterrents to me buying the stock. There are risks in all stocks and there is still a lot of value in Rolls-Royce, in my view.
The reason why I will not be buying it now is that I already own another company in the sector.
BAE Systems is in very similar businesses to Rolls-Royce. It has also seen its share price rise dramatically in the past year or so. And it looks very undervalued to me as well.
That said, I was able to buy it earlier at a much lower price, giving me even more potential profit.
And unlike Rolls-Royce, it has a dividend yield – only a modest 2.3%, but it has paid more before and may again.
If I did not have this holding then I would probably buy Rolls-Royce shares, even at the current price.
In my view, there is a lot of value left in the stock, and the business looks set for significant growth over the long term.
