Rolls-Royce (LSE:RR) shares have been among the strongest performers on the FTSE 100 in recent months. The stock is now up 33% over the last quarter, but is down 10% over 12 months. However, despite the recent rally, I still believe the engineering giant is undervalued. Let’s explore why.
Valuation
The shares were described as “woefully mispriced” by Morgan Stanley last summer. The bank said their earnings recovery was “much closer than the market has priced in, while earnings and cash flow are directly geared to the next leg of a global aviation recovery”.
Since then, the stock has gained around 15%, but evidence suggests it still has further to go.
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To start, near-term metrics suggest the company is cheaper than its peers.
| Rolls-Royce | Sector average | |
| Price-to-sales | 0.77 | 1.39 |
| EV-to-sales | 1.22 | 1.82 |
| EV-to-EBITDA | 22.6 | 17.5 |
| EV-to-EBITDA (forward) | 10.6 | 11.3 |
| Price-to-cash flow | 8.82 | 16.98 |
As we can see, according to several metrics, Rolls does look cheaper than its peers.
These findings are broadly corroborated by the discounted cash flow (DCF) model. A DCF model is based on the idea that a company’s value is determined by how well it can generate cash flows for its investors throughout the course of an investment.
A DCF calculation with an exit at 10 years suggests Rolls is undervalued by 27%. The analysis suggests a share price range of 88.8p to 238p, and a fair value of 136p.
Collectively, these valuation metrics suggest that Rolls remains undervalued at its current position. This forms the core part of my investment decision-making process.
Reasons for optimism
Rolls has faced some considerable challenges in recent years. Civil aviation, its bread and butter, accounts for more than 40% of its total revenue. After a period of pandemic-induced crisis, this segment is now growing again.
The firm manufactures aircraft engines, primarily for wide-body aircraft like the Airbus A350 and Airbus A330neo. These aircraft tend to be used for long-haul flights, and this has been a slower area of the sector to recover. But 2023 looks different, especially with China reopening. Wide-body aircraft tend to be used on domestic flights in China.
Looking at defence, the company’s second-largest sector, analysts are broadly in agreement that the war in Ukraine will mean greater defence spending in the coming years. In 2021 it won a $2.8bn contract for B-52 bombers from the American government, and in 2022 it gained a deal worth as much as much as $6bn for next-generation rotary US rotary craft.
Analysts have also tipped the new UltraFan engine to be a game-changer for the firm. The 140-inch diameter power unit is capable of producing 64MW of power. It can also run on 100% Sustainable Aircraft Engine Fuel (SAF) from day one of service. SAF is considerably less polluting than regular fuel.
Risks
While I’m buying more Rolls shares, I’ve got to be aware of the risks. Debt is one of the challenges facing it. Rolls still has £4bn in debt obligations — all on fixed interest rate terms — maturing between 2024 and 2028. The fixed term rates are certainly positive for the firm, but the burden is likely to impact profitability moving forward.
