The discounted cash flow model is a popular metric for valuing a company. Currently, by my calculations, it yields an enterprise value of around £11bn for Rolls-Royce (LSE:RR) shares. The equity value, by contrast, stands at around £7.5bn, suggesting a fair value for the shares is a little over £1 each – 33% higher than current prices.
However, I want to make sure my stock picks will outperform the market average. Even with value attributes, I think there are some deeper structural challenges facing Rolls-Royce.
I think it’s worth exploring the specific factors affecting its intrinsic value and noting the pressures it faces going forwards.
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Restructuring efforts
After big losses in 2016, Rolls-Royce took some drastic actions. It made a reduction to its staff headcount amounting to 5,500 personnel. This reduced annual outgoings by £400m. The pandemic increased the headcount reduction to a total of 9,000 personnel.
Rolls-Royce hoped this would save it £1.3bn by the end of this year. But has this reduced its capacity for growth going forward?
Before the pandemic, Rolls-Royce’s operating expenses steadily declined. Revenue did continue to grow during this time. However, profit margins did not, and Rolls-Royce remains unprofitable at present with 2022 interim earnings of -£1.8bn.
Loss of demand
Given the global economy’s recent depression, it has been hard for the aviation and power systems industry to drum up orders. Rolls-Royce shares have certainly fallen victim to this.
Almost 50% of Rolls-Royce’s revenue comes from its Aerospace division. Revenue generated in this sector is derived from new engines sold, engine usage, and service agreements. Analysts do expect the aviation industry to return to 2019 levels, but no sooner than 2023.
For the large aircraft engine sector, 8.7% year-on-year growth is expected for the global market size for the next 10 years as a best-case recovery scenario.
Furthermore, the marine market has analysts predicting an annual growth rate of 4% for the next 10 years. This subtends from a surge in demand for environmentally sustainable power systems.
Overall predictions see Rolls-Royce quickly reclaiming the share price growth it has lost in the event of an economic turnaround.
The catch
To survive the pandemic, Rolls-Royce holds almost £7bn in debt. With rising interest rates, financial costs are increasing and will be pressuring profitability.
As a result, Moody’s Investors Service downgraded Rolls-Royce to a Ba3 rating with its increased credit risk. This ultimately makes it harder for the company to strike deals and increases the cost of its bonds, as it has a higher probability of insolvency.
However, Rolls-Royce is taking debt disposal seriously. The deal to sell ITP Aero for 1.7bn in 2021 is promising evidence that the company will be able to raise enough cash to avoid further expansion of its debt. Over time, I expect its debt-to-equity ratio to steadily reduce.
To conclude, I think the growth rate of Rolls-Royce will be slow and steady for the next 10 years. It faces a lot of financial headwinds. However, I wouldn’t be against investing in the medium term to benefit from the share price potentially rebounding to fair value.
At this time, I don’t think we have seen the lows for Rolls-Royce yet. I’ll be keeping an eye on its share price into next year before deciding whether to buy into the company or not.
