The price tag for an aircraft engine made by Rolls-Royce (LSE: RR) can be hefty. Buying a stake in the company, by contrast, can require only pocket change. The Rolls-Royce share price is in pennies. It has fallen 46% over the past year.
But with the business showing signs of recovery, could this be the time to add to my existing holding?
Long-term investing
My answer to this is driven by my philosophy of long-term investing. While the Rolls-Royce share price has moved around a lot in the short-term, my focus is on what I think the company will be worth five or even 10 years from now – and whether today’s share price offers me a bargain on that basis.
To do that, I could use a number of valuation techniques. For example, I might look at the company’s discounted future cash flows Alternatively, I could use its prospective price-to-earnings ratio, based on what I think the firm’s future earnings might be.
Turbulent times
The challenge that faces me as an investor, no matter what valuation technique I adopt, is that there are a lot of unknown elements about the future financial prospects for the aeronautical engineer.
Dramatic demand swings for passenger flights over the past several years were a sudden, unexpected event. That hurt not only engine sales but also servicing revenues from the company’s large installed base. There is a risk the same thing could happen again, whether due to a pandemic, terrorist event, or unexpected weather phenomenon as seen with an Icelandic volcano in 2010.
High fuel prices and mounting regulations concerning fossil fuel use are another unknown. On one hand they present an opportunity. Rolls-Royce is developing a line of engines designed for alternative energy sources. But such new product development tends to be costly. The end result is not guaranteed to find favour with purchasers.
Solid business foundation
Despite such variables, we do know quite a few things I think will likely impact the company’s future prospects.
For example, that large installed base should keep generating servicing revenues for years to come. Growing anxiety about national security across Europe also looks set to help bolster the long-term growth outlook for Rolls-Royce’s defence business.
On top of that, I find the basic business model highly attractive. Designing, making and servicing engines is highly specialised. So the industry has high barriers to entry. Rolls-Royce only has a few big competitors, which can help it sustain pricing power. Engines are mission-critical, further enhancing its pricing power.
It has also been recovering from the challenging business environment of the past several years. The firm now forecasts “good” revenue growth and improved profitability for this year compared to last.
My move on Rolls-Royce
Set against that, the company’s current market capitalisation of £6.3bn looks cheap to me, given the long-term prospects of the business. Admittedly, it has a sizeable debt pile, but the recent sale of ITP Aero could help to reduce that.
As a long-term investor, if I did not already have a sizeable holding, I would see the current Rolls-Royce share price as a buying opportunity for my portfolio. Mindful of the need to keep my portfolio diversified, I do not plan to buy more right now — but will keep my stake.
