The Rolls-Royce (LSE: RR) share price looks cheap, compared to its trading history. At around 130p, the stock is trading at a significant discount to its five-year high of 375p per share. However, these figures only indicate market sentiment. They do not tell us much about the underlying business.
Unfortunately, the fact is the underlying business has deteriorated significantly over the past couple of years. The pandemic slammed into the company at the beginning of 2020, and management had to take evasive action to stave off collapse.
Rolls slashed thousands of jobs and sold off some of its non-core businesses. This suggests the company is now smaller than it was when the stock was changing hands at 375p. As such, it makes sense the shares are trading at a lower level.
But with the company now well on the way to recovery, is the Rolls-Royce share price undervaluing the firm’s potential?
Return to growth
According to the company’s latest trading update, it has returned to a positive cash flow position after making deep cuts to staff and operational costs. Although the company still expects to report a free cash outflow of £2bn for 2021 as a whole, free cash flow turned positive in the third quarter.
In the year ahead, the company is looking to generate £750m in cash if flying hours reach 80% of pre-pandemic levels. That is a stretch, but it is not impossible. Flying hours in the United States surpassed pre-pandemic levels during the past couple of weeks. Activity on global long-haul routes is also recovering.
Of course, there will always be the risk that another coronavirus variant will emerge to disrupt the recovery. This is probably the most considerable risk facing the company right now, and it is one that is virtually impossible to analyse and control.
Still, if I overlook this factor for a second, it is clear that the Rolls-Royce share price appears cheap at current levels.
Rolls-Royce share price value
If the company can generate £750m in cash for the year ahead, the stock is currently trading at a cash flow yield of 6.9%. This is above average for the company in the market. A more appropriate value would be a cash flow yield of around 4%.
This suggests the company could command a market capitalisation of about £17bn. In this scenario, the stock price could hit 240p.
This is just a back-of-the-envelope-type calculation. As noted above, there is no guarantee the company will hit its cash flow targets. The outlook for the aviation industry is highly uncertain. It seems unlikely this will change over the next couple of years.
Still, these numbers suggest to me that the company has significant potential. They also suggest the Rolls-Royce share price looks cheap at current levels. On that basis, I would be happy to buy the stock as a speculative investment for my portfolio.
