Rolls-Royce (LSE: RR) shares have risen a long way from their 23 October 12-month traded low of £1.97. But as it consolidates its position in the elite investment grade of companies, I think it may well go higher over time.
However, I already have a holding in BAE Systems (LSE: BA) that operates broadly in the same business space.
To own both might unbalance the risk-reward profile of my stock portfolio. So, which one looks best for mw to own right now?
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Relative valuations
On the key price-to-earnings (P/E) stock valuation measurement, Rolls-Royce trades at 17.9. BAE Systems is at 20.7.
Both firms occupy the bottom two spots in their competitor group, which has an average P/E of 43.3. So, both look very cheap on that basis.
A discounted cash flow analysis shows Rolls-Royce to be 54% undervalued at its present price of £5.25. BAE Systems is 23% undervalued at £12.75.
Therefore, a fair value for Rolls-Royce shares would be £11.41, and for BAE Systems £16.56. Both could go lower or higher, given the vagaries of the market, of course.
Nonetheless, a win here for Rolls-Royce, I think.
Revenue and earnings prospects
A company’s share price (and dividend) are ultimately driven by rises in revenue and earnings. Revenue is the total money a firm receives, while earnings are the money left after expenses and tax.
Consensus analysts’ estimates show a major difference between the two firms’ prospects in one key regard to 2027.
Revenues at both are expected to climb: up 5.5% a year at Rolls-Royce and up 8.7% annually at BAE Systems.
But earnings at Rolls-Royce are expected to fall to end-2027 (albeit by just 0.09% a year), while BAE Systems’ are forecast to rise 7.3% annually.
A risk to Rolls-Royce is that its production capabilities do not keep up with its fast sales growth. This could lead to costly failures in products.
For BAE Systems, a risk is poor management of its foreign exchange exposure, given its huge international order book. This could produce big currency losses on market fluctuations.
Overall, though, a win here for BAE Systems, in my view.
Dividend yield generation
BAE Systems paid a total dividend in 2023 of 30p a share. This gives a yield on the current £12.75 share price of 2.4%.
Analysts predict this will increase to 2.8% in 2025 and 3.1% in 2026.
Rolls-Royce currently pays no dividend but says it will introduce one this year. Analysts expect a 1.1% yield in 2025 and 1.6% in 2026.
So, a second win – and overall victory – for BAE Systems.
Which would I buy?
My holding in BAE Systems was built up over many years at a much lower average price than today’s. So, I am extremely content with this position.
That said, I would happily buy it today if I did not already own it. It has tremendous growth prospects in a strongly expanding sector, I think. And it also pays a reasonably decent dividend as well.
Nevertheless, I am a big fan of Rolls-Royce too. It also benefits from the burgeoning defence sector and should continue to do well, I think.
However, I would not have two stocks in the same sector at present, and BAE Systems is still my number one choice in the field.
