Over the past 12 months, the Rolls-Royce (LSE:RR) share price has been on a bit of a wild ride. In fact, over the past five years, shares in the aerospace giant have been incredibly volatile.
The stock traded as high as 375p in August 2018. However, by the beginning of October 2020, it had lost more than 90% of its value. Since then, the stock has recovered, but it still trades around 70% below its five-year high.
The Rolls-Royce share price conundrum
The thing is, Rolls’ underlying business is nowhere near as volatile as its share price. The equity volatility suggests the firm is exposed to short-term agreements, which are impossible to predict. The reality is entirely different.
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The company sells aircraft engines on multi-year service contracts and also has a contract to maintain the nuclear reactors in the Royal Navy’s submarines.
Granted, the corporation has had to deal with some significant challenges in recent years. These continue to rumble on in the background. Disruption to the aviation business from the pandemic, and some engineering issues, have cost the company a significant amount of money.
Until the global aviation industry has fully recovered from the disruption of the pandemic, Rolls is unlikely to return to full health.
Still, management thinks the enterprise will generate around £750m in free cash from operations this year. This gives me a fundamental waypoint with which to value the company.
Rolls has a market capitalisation of just under £10bn, at the time of writing. If the firm can hit its cash generation target, the stock has a free cash flow yield of 7.5%. By comparison, other businesses are trading with a free cash flow yield of around 3-4%.
Undervalued
The Rolls-Royce share price may not warrant the same valuation, but I do not think it is unreasonable to say that the stock looks cheap compared to its peers. Even if the firm’s valuation moves to a free cash flow yield of 5-6%, the stock could rise 30-40% from current levels.
Of course, these figures are just estimates. There is no guarantee the company’s valuation will rise to the market average. Neither is there any guarantee the enterprise will meet its free cash flow generation targets.
Nevertheless, I think these numbers clearly illustrate that the Rolls-Royce share price is worth significantly more than it is currently trading for in the market.
Based on this analysis, even though the company does face some significant challenges in the year ahead, I would be happy to buy the stock for my portfolio today as an undervalued recovery play.
I think that as the aviation industry rebounds from the pandemic, investors will return to the sector. This could drive the company’s valuation back to the market average multiple.
So while it might take a couple of years, I think the real value of the stock is significantly higher than the current price. My price target would be around 155p, an increase of 35% from current levels.
