Rolls-Royce’s (LSE: RR) share price has nearly tripled over the past 12 months. However, just because a stock has significantly risen in price, does not mean there is no value left in it.
It could be that the company is simply worth more than it was before. In fact, it may be worth even more than even the higher share price reflects.
Can it really be undervalued at £4+?
There are risks in the shares, as in all stocks. Another pandemic would cripple its civil aerospace revenues (comprising 44% of its business). A major problem in its key defence sector products would also be very costly to it.
However, Rolls-Royce shares at £4.16 trade on the key price-to-earnings (P/E) stock valuation measurement at just 14.5.
This is less than half its peer group average of 29.1, despite its recent price rise. So, it still looks a bargain to me.
But how much of one is it? A discounted cash flow model shows it to be 52% undervalued at the present price. Therefore, a fair value for the stock would be about £8.67.
The shares may never reach that point, of course. But the key point is that technically, they are very undervalued against their peers, even at £4+.
What will cause the next move up in price?
In its December 2023 Investor Presentation, Rolls-Royce laid out three elements it sees as pivotal in its future.
The first is to be “high performing, competitive and resilient”. The second is to generate “growing sustainable cash flows”. And the third is to have “a strong balance sheet and growing shareholder returns”.
These qualities will form the foundation of a higher-value company rated in the elite ‘investment grade’ of global firms. This status will give it more preferential access to capital, which can then be used to drive further growth.
28 March saw major credit ratings agency Fitch upgrade Rolls-Royce to investment grade BBB-. As it now stands, all the big three agencies — including Standard & Poor’s (S&P), and Moody’s — rank Rolls-Royce at this elite level.
As part of its push to cement this new status, it unveiled key financial targets to be achieved by 2027.
These are operating profit of £2.5bn-£2.8bn, operating margin of 13%-15%, and return on capital of 16%-18%. All reflect major growth in the company to that point.
It also aims for free cash flow of £2.8bn-£3.1bn by that time. This cash pile can provide another major boost to growth.
Should I buy?
A key factor in stock selection is where the investor is on their investment journey. I turned 50 a while back, so my investment priorities now are different to those I had at 20.
At that age, I mainly bought growth stocks that I thought would make tremendous price gains over 30 years.
At 50, I sold nearly all my growth investments and replaced them with stocks that paid very high dividends. These should allow me to continue to reduce my working commitments.
Currently, Rolls-Royce does not pay any dividend, so it simply does not qualify for my investment consideration.
However, if I were 20 and starting my investment journey, it is exactly the sort of stock I would buy. Even at £4+, it appears extremely undervalued to me, and looks set for stellar growth.
