The Rolls-Royce (LSE: RR) share price has tumbled 17% since midday on Wednesday, and currently sits about 4.5% down from the opening today. This brings the share price to around 71p, levels not seen since 2004. The year so far has been a tough one for the firm, with demand almost non-existent following the impact of coronavirus.
As a result, it recently announced a rights issue intended to generate cash flow, at a time when net debt is rising. From a figure of £993m of last year, forecast net debt for the end of 2020 currently stands at £3.5bn. In order to try and reduce costs, Rolls-Royce announced this week that it would be cutting around 1,400 aerospace jobs. This was the main driver that has seen the Rolls-Royce share price tumble in the short term.
Is the current share price fair value?
A lot of investors are wondering whether the current price is a good one. I’ve been on the sidelines as well, waiting to invest at a price that makes sense. I last covered the stock a few weeks back, when the share price had shot up to 223p. I decided to wait then, which proved to be a good call. Apart from gut feelings, what metrics can I look at to try and put a fair price on Rolls-Royce?
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I can’t viably use the price-to-earnings ratio or even earnings-per-share given that the firm is in a loss-making position, so have to look elsewhere. The market capitalisation of the firm stands at £5.94bn. The enterprise value is calculated at £5.93bn. This enterprise value is an alternative way to value a company, aside from the public listing value. In this case, values are similar, which indicates to me that the current share price at 71p fairly accurately prices the value of Rolls-Royce.
What’s the downside risk?
So if I conclude the price is fair, what is the downside risk? The major risk here is that debt continues to rise, and either cash or other assets can’t keep pace. This would decrease the overall net asset figure, and reduce the enterprise value. In turn, this could have a knock-on impact on the share price, as investors reduce expectations for future revenue and profits.
For example, let’s say the enterprise value falls by £1bn next year and the market capitalisation mirrors this exactly. If the market cap sat at £5bn, and the number of shares stayed the same, the Rolls-Royce share price would be at 59.7p. For those who want the numbers, this is based on 8.37bn shares outstanding, and a share price of 0.71 (71p).
So as an investor, I’d say around 60p is as low as the Rolls-Royce share price could go if things worsened in the next year. This is the level that I’m looking to buy at. The caveat (there always is one) is that my assumption is on the value falling by £1bn. This value could be hit, mainly if we see a continuation of low demand and a lack of control of the pandemic continuing into 2021.
