Rolls-Royce (LSE: RR) shares have risen over 200% over the past 12 months, leaving many investors in a quandary.
For some, such a move signals that they should jump on the bandwagon, or they will miss out. For others, it cautions that they should avoid the shares, as they are too expensive.
In my experience as a former investment bank trader, neither view is conducive to making big, long-term investment returns.
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The only question that should be asked in my view is whether there is value left in the shares. If there is, then they may well be worth buying, depending on the circumstances of the investor.
Still undervalued?
Despite the recent price rise, Rolls-Royce shares currently trade at just 15.8 on the key price-to-earnings (P/E) stock valuation measurement.
Compared to their peer average P/E of 29.6, they look very undervalued.
But by how much precisely? A discounted cash flow analysis shows the shares to be 48% undervalued at the present price of £4.62. So a fair value for the stock would be about £8.88.
There is no guarantee they will reach that point, but it highlights just how undervalued they still look.
This seems even more the case to me, given the company’s stellar results in 2023.
Its underlying operating profit increased 144% to £1.59bn from £652m in 2022. Its free cash flow soared 154% to £1.85bn. And its return on capital more than doubled from 4.9% to 11.3%.
Next catalysts for share price gains?
A risk for the company is that another pandemic (or other big crisis) would cripple its civil aerospace revenues (comprising 45% of its business). A major problem in its key defence sector products would also be very costly to it.
However, back in December, it laid out key performance forecasts to 2027. These included an operating profit of £2.5bn-£2.8bn, an operating margin of 13%-15%, and a return on capital of 16%-18%. It also aims for free cash flow of £2.8bn-£3.1bn by that time.
On 23 May, it stated that this year alone underlying operating profit could increase by as much as 25% — to £1.7bn-£2bn.
It also said that its civil aerospace unit could finish this year at up to 110% of its pre-Covid flying hours.
It additionally underlined the importance of its recently achieving the coveted investment-grade status from the three major credit ratings agencies. This will give it more preferential access to capital, which can then be used to drive further growth.
Will I buy it?
I already own shares in BAE Systems, which operates in the same sector, so adding another would unbalance my portfolio.
Additionally, having turned 50 a while ago, I am focused on companies that pay dividends. Rolls-Royce currently does not. However, it has indicated it will do so in the future, as part of its new investment-grade company status.
This said, if I was even 10 years younger, and without other similar holdings, I would buy the stock now.
It has great growth prospects and is still highly undervalued, in my view.
