It’s one of the Footsie’s star performers following the end of the pandemic. And the Rolls-Royce (LSE:RR.) share price isn’t showing signs of running out of steam just yet.
At 331p per share, the FTSE 100 engineer is up 11% since the start of 2024. It continues to be lifted by positive news flow coming from across the world’s airline industry.
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Using one popular metric — the forward price-to-earnings (P/E) ratio — the plane engine producer now looks a tad expensive, some market commentators argue. At 26.6 times, this is more than double the Footsie average of 11 times.
But based on another widely used metric — the price-to-earnings growth (PEG) multiple — Rolls-Royce’s share price actually looks dirt cheap.
At just 0.8, this is below the benchmark of 1 that indicates a stock is undervalued. This is based on City predictions that annual earnings will soar 32% in 2024.
I still have reservations about buying the stock for my portfolio, however. What should I do next?
The case for
As I say, a slew of strong updates from airline companies has boosted Rolls-Royce shares of late. In the last week, Air Canada has followed major operators across the US and Europe in releasing strong financials for last year.
In fact, Canada’s largest airline hiked its profit forecasts for 2024 after announcing a 10% improvement in passenger numbers between December 18 and January 6.
A strong airline industry is critical for Rolls’ top and bottom lines. Almost half of its revenues came from Civil Aerospace in the first half of 2023.
Encouragingly, the outlook is also robust for its Defence division. I expect sales of its military hardware to climb as Western countries rapidly rebuild their armed forces.
The case against
But I still have a problem with buying the shares today. In particular, demand for air travel could disappoint in 2024, and potentially beyond, if economic conditions worsen in key regions like the US and China. Airline activity may also stumble if interest rates fail to reverse from current levels.
And while rising conflict is boosting the firm’s defence division, this is creating turbulence for the airline industry, thus posing an indirect threat to Rolls’ Civil Aerospace unit.
This bothers me as Rolls has to repay a large portion of its £2.8bn net debt over the next two years. Any trouble in its end markets could therefore impact the amount of cash it has to spend on its capital-intensive growth programmes. It may also delay when the company is able to begin paying dividends again.
The verdict
While Rolls-Royce shares look cheap on paper, I’m still not convinced I should spend my hard-earned cash on them.
A fresh downturn in the airline industry — combined with the stress this would put on the company’s balance sheet — may completely change the complexion of the firm’s investment case and pull its share price sharply lower.
I don’t think I need to take a big risk to obtain decent value, either. Primark owner Associated British Foods, sportswear giant JD Sports and life insurer Aviva are just a few Footsie shares that also carry sub-1 PEG ratios today. So I’m happy to avoid Rolls shares and buy other blue-chip stocks for my portfolio.
