Image source: Rolls-Royce plc
Rolls-Royce‘s (LSE: RR) share price lost ground after the release of free Q3 trading on 7 November.
There are two things in this that caused the decline, in my opinion. Another was that aerospace, defense and energy systems kept the 2024 full-year vision instead of expanding it. Second, it was highlighted that the aerospace industry’s supply chain is still challenging.
The aerospace industry will obviously continue to work to address this resource shortfall. Given the power of the financial sector and collective intelligence, I don’t see this as a permanent problem.
The most serious risk I see for Rolls-Royce is any further questions about the reliability of its latest aircraft engines. On 2 September, there was a failure in the aircraft at Cathay Pacific A350-1000 Rolls-Royce XWB-97 engine.
And in the first half of the price cut, Rolls-Royce had already dramatically improved its 2024 guidance earlier this year.
Specifically, its H1 2024 results released on 1 August are consistent with its underlying operating profit estimate rising to £2.1bn-£2.3bn from £1.7bn-£2bn previously. It also raised its free cash flow forecast to £2.1bn-£2.2bn from £1.7bn-£1.9bn previously.
A long-term vision
The updated guidance issued three months ago was well-founded, in my view. In the first six months of the year, Rolls-Royce saw year-on-year profits jump 74% to £1.149bn. Free cash flow rose 225% to £1.158bn.
These numbers also prompted the company to raise its guidance to 2027, which it still holds. Specifically, this forecasts £2.5bn-£2.8bn in operating profit over the period and £2.8bn-£3.1bn in free cash flow.
As the company also highlighted in its trade review, major credit rating agencies around the world also agree with Rolls-Royce’s prospects. All three – Moody’sFitch, too Standard & Poor’s (IS&P) rated in the elite bracket of ‘investment grade’ firms.
In its Aug. 21 ratings update for the firm, S&P forecast adjusted earnings before interest, tax, depreciation, and amortization at 18%-19% in 2024 and 2025. It also showed free cash flow of £2.1bn-£2.3bn in the same years.
These ratios indicate how much debt firms can access and at what cost. They also influence how willing financial institutions are to negotiate future growth opportunities.
Are shares irrelevant?
On the price-to-earnings ratio of the stock, Rolls-Royce trades at just 19.8. This compares to an average of 33.5 for its competitors, so it is very cheap on this basis.
The same is true for the price-to-sales (P/S) ratio. Here the company is currently at 2.6 compared to a competitive average of 3.6.
To translate all of this into share price terms, I used a discounted cash flow analysis using other analysts’ calculations as well as my own.
This shows that Rolls-Royce shares are worth 51% at their current price of £5.46. Therefore, the fair value of the stock is £11.14, although it could be lower or higher than that.
Should I buy the stock?
I already own another stock in the same sector (BAE Systems) so someone can measure my portfolio.
However, if I didn’t have it I would buy Rolls-Royce shares today for their very strong growth prospects.
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