Just because I think a stock looks cheap on face value does not necessarily make it a bargain. I made this exact point in June back when the Rolls-Royce (LSE:RR) share price was just under 90p.
The aerospace giant’s shares have not stopped bleeding in value since. Nearly a fifth of its value has been slashed over the last month alone. For a relatively small company, I believe the recent sell-off in its shares has been outsized.
Why the share price keeps tumbling
My view is that the sell-off may be due to a couple of headline factors, all concerning inflation.
First is wage inflation. The company recently decided to reward its staff with a £2,000 bonus to deal with the rising cost of living. The offer also included a 4% wage hike. I feel it is a fitting gesture for employees, but not for shareholders. Furthermore, I sense there could be an even bigger wage hike on the cards if the worker unions get their way.
Second is price inflation for the raw materials the company consumes. The costs of titanium, steel, and aluminium — metals the company rely on — are all up.
These factors make long-term profitability a pipe dream for Rolls-Royce. Bear in mind it is already a loss-making company.
Are Rolls-Royce shares cheap now?
Do I think the share price of 70p is reflective of the actual value of the stock? Or is it currently undervalued, providing me with an opportunity to buy?
I am a value investor at heart. So, one of the only reasons I’d buy Rolls-Royce was if it was offering me growth at a cheap price.
The company is forecast to grow revenue in the double digits over the next couple of years. The problem is that I foresee its liabilities growing simultaneously — as is the case with the rising costs its grappling with currently.
Even at the current price, the company’s price-to-sales ratio is not too far behind the sector average. This suggests to me that the stock is already valued in line with the industry norm.
Therefore, I believe the stock’s growth potential, no matter how positive, may already be factored into its current valuation. From this perspective, I do not believe the Rolls-Royce share price is cheap.
Long-term bearish trend
The overriding narrative for me with Rolls-Royce is that it is just too volatile a stock for me to tolerate. Over the past three years, the share price movement looks like an Alton Towers roller-coaster!
Volatility can be positive, but in the case of Rolls-Royce, the valuation has looked too downtrodden for my liking. The share price is a bit above 70p now, but was as high as 300p in 2019.
In my perspective the sharp decline in its share price over the last three or four years may reflect a broader correction by the market. I am inclined to think that the current price better reflects the business’s long-term potential.
I would not be surprised if the shares fell to the 50p mark come the end of this year.
