The Rolls-Royce (LSE:RR.) share price has delivered spectacular growth in recent years. No other FTSE 100 stock comes close to matching its 568% advance over five years.
With the shares trading for £7.24 each today, does the British engineering giant offer good value for new investors? Or has optimism surrounding the business already been priced in?
Here’s my take.
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Valuation metrics
To ascertain whether the Rolls-Royce share price is still cheap, it’s worth starting by looking at widely used valuation metrics.
Let’s begin with the price-to-earnings (P/E) ratio. Rolls-Royce shares currently trade for a P/E multiple of around 24.4. On a forward P/E basis, they’re even pricier with a ratio of nearly 31.
Compared to the average 16.3 times multiple across FTSE 100 stocks, the jet engine maker seems expensive. That’s a risk for investors today. It suggests there’s little room for error in the company’s financial results, and future shareholder returns may not be as promising as they’ve been in recent years.
The P/E-to-growth (PEG) ratio can provide further clues, since this metric accounts for expected revenue improvements. Traditional investing wisdom dictates that a PEG ratio below one is a good sign that a stock’s potentially undervalued.
Unfortunately, the expected five-year PEG multiple for Rolls-Royce is nearly 2.3. That’s another signal that the stock isn’t the bargain it once was. At least investors can take solace in the fact that these numbers look more reasonable compared to US industry competitors like GE Aerospace and Honeywell International, even if not against other UK shares.
Paying a premium
Overall, it’s fair to say there are valuation risks associated with the Rolls-Royce share price today. But numeric formulas aren’t everything. Legendary investor Charlie Munger was famously sceptical of their utility. He viewed investing as both an art and a science.
So, how does Rolls-Royce stack up on some key tests Munger used to assess a stock’s true value?
First, the business needs a strong competitive advantage and a wide economic moat. Here, I think the company triumphs. Rolls-Royce’s aircraft engines have a longstanding reputation for their high quality, reliability, and efficiency.
On defence, the firm’s a preferred supplier to the UK government, evidenced by the recent £9bn contract awarded to support the Royal Navy’s nuclear submarine fleet. Furthermore, Rolls-Royce has been a pioneer in developing small modular reactor technology, which could prove critical in supplying low-carbon energy.
Second, Munger placed great importance on a company’s management. Few would doubt the abilities of Rolls-Royce CEO Tufan Erginbilgiç. Having taken over what he described as a “burning platform“, he’s transformed the business into a highly profitable enterprise, restored the firm’s credit rating to investment grade, and resumed dividend payments.
Third, financial strength is also crucial. There’s a lot to like on this front. Rolls-Royce’s operating margin has improved to 13.8% from 5.1% in 2022, free cash flow climbed in the same period from £0.5bn to £2.4bn, and return on capital increased from 4.9% to 13.8%.
Although the Rolls-Royce share price probably isn’t undervalued today, I think today’s level is a fair reflection of the investment opportunity. It’s a stock that still deserves consideration in my view, and I hope Munger would agree if he was still with us!
