When I first looked at Rolls-Royce (LSE:RR) shares earlier in the year, I thought it was grossly overvalued. I still think it could be, but some industry experts think the shares might climb higher.
So, I decided I’d take a look at the positives the company is offering and weigh these up in more detail against the valuation risks I had previously observed.
Jet engines, defence, and power
Rolls-Royce is a leader in aerospace, defence, and power. However, its main revenue driver is its supply of jet engines for commercial planes. Therefore, a lot of the company’s revenue is heavily dependent on the commercial travel industry.
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The organisation is one of four main jet engine manufacturers, the other main ones being GE Aerospace, Safran, and Pratt & Whitney (owned by RTX).
Arguably, it’s very hard for new competitors to arise. After all, developing jet engines is not cheap and requires all the right contacts and associated reputations.
2024 looks bright
This year, the firm is expecting its operating profit to increase by 16.5% from 2023. It also expects its free cash flow to grow by 50%. Those are some very promising numbers.
These expectations come after a resoundingly strong last year for Rolls-Royce when its revenues grew by 21%, and its operating profit grew by 143%.
My hope for the firm is that it can flesh out its defence and power segments more. If it can manage to make these nearly as compelling as its jet engine business, I think the long-term opportunity here could be viable.
But the real element that’s got investors excited at the moment is the firm’s new focus on efficiency after the pandemic. It’s certainly done a good job of recovering, so let’s see if it can keep on growing now it’s back on its feet.
It’s the valuation I’m concerned about
Some people think Rolls-Royce is selling for cheap because its price-to-earnings ratio is lower at the moment than over the past decade.
But there’s another way of looking at earnings which takes into account something called non-recurring items. These are profits that are one-off occasions, like the sale of assets.
I think Rolls-Royce might look to have higher earnings at the moment because of its ‘period of efficiency’, where it’s likely selling off its inefficient assets. That will artificially make its valuation more appealing for a while by making it look like it has higher earnings.
Typical, Generally Accepted Accounting Principles (GAAP) won’t account for this. So, investors might be getting a bit carried away with profits that won’t be recurring. I don’t think the market has priced this into the stock valuation correctly.
Will the rally continue?
I think for most investors, the valuation of Rolls-Royce is both fragile and difficult to assess.
Maybe earlier in the year, the shares may have offered great value as a turnaround play. After all, the firm was in dire straits during COVID-19, and the new CEO seems to be doing a good job.
But right now, I think it’s risky. At best, it is priced for perfection, if not overvalued, in my opinion. I think when the efficiency period stabilises, investors could lose some of their enthusiasm for Rolls-Royce. Then, the price might come down. So, I’m not buying it right now.
