Stock market

Why Rolls-Royce’s share price could outperform

Image source: Rolls-Royce Holdings plc

Let there be no suspense – I think Rolls Royce (LSE:RR) share price still looks like a bargain after a 197% gain over the past year. And last week’s news seemed to confirm that.

The company announced that engine hours had returned to 2019 levels and reiterated its targets for the year. The stock didn’t react, but I think the market is making a mistake.

Bell case

I believe the bull case for Rolls-Royce shares has been the same for some time. The company aims to achieve £3.1bn of free cash flow by 2027.

Simply put, I think the stock is a great value if the underlying business can achieve it. The firm has a market cap of £37bn, which means £3.1bn a year equates to an 8.3% return.

This is double the return currently offered by a 10-year UK government bond. So if things go to plan, the stock will look like a bargain at today’s prices.

Obviously, Rolls-Royce may not achieve its targets until 2027 and the stock should reflect that risk. But with things going to plan, I maintain that the share price should be higher than that.

Trading Update

Last week, the company announced that engine flight hours had returned to pre-Covid levels. And the administration reiterated its forecast for the current year.

Both these developments are very positive in my view. Underlying the recovery in Rolls-Royce’s share price is a return to pre-pandemic demand for flying.

This has left the company on a virtuous cycle. Higher free cash flow led to lower debt, which led to lower interest payments, which led to higher free cash flow – and so on.

All this is pushing the stock higher and the latest update indicates that things are going well. However, the share price was largely unmoved by the latest news.

Optimism

I’m seeing reports that the number of engine flight hours was expected to be even higher. This probably explains the subdued market response.

As I see it, the company is doing just fine given its stated goals and current stock levels. But it points to a real risk with business.

If travel demand begins to decline, Rolls-Royce could see its growth slow significantly. And that could jeopardize the 2027 target on which the bullish thesis is built.

The rising cost of living makes it impossible to completely eliminate this risk. But that’s why I think the latest update reaffirms that things are on track is a major positive.

Still a bargain?

At today’s prices, I’m not sure Rolls-Royce needs anything spectacular to be a good stock value. It just needs to stay on track to meet its medium-term goals.

Every time a company reports that this is the case, I think the risk with the stock decreases and the share price should go up. Even if it is the best. FTSE 100 Buying the stock now is another question, but I definitely expect it to outperform the index.


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