Stock market

Even at around £4.60, Rolls-Royce shares still look extremely undervalued to me.

Image source: Rolls-Royce plc

Rolls Royce (LSE: RR) shares have risen more than 200% in the past 12 months, leaving many investors worried.

For some, such a move signals that they must jump on the bandwagon, or else they’ll miss out. For others, it warns that they should avoid shares, because they are too expensive.

In my experience as a former investment bank trader, neither theory is conducive to large, long-term investment returns.

In my view, the only question that should be asked is whether the shares have value left. If there is, they may be worth buying, depending on the investor’s circumstances.

Still undervalued?

Despite recent price gains, Rolls-Royce shares currently trade at just 15.8 on the key price-to-earnings (P/E) stock valuation measure.

Compared to their peer average P/E of 29.6, they look very undervalued.

But how accurately? A discounted cash flow analysis shows that 48% of the shares are undervalued at the current price of £4.62. So a fair value for the stock would be around £8.88.

There’s no guarantee they’ll make it to that point, but it does highlight how unlikely they still seem.

Given the company’s stellar results in 2023, this seems even more the case to me.

Its underlying operating profit rose 144% to £1.59bn in 2022 from £652m. Its free cash flow rose 154% to £1.85bn. And its return on capital doubled from 4.9% to 11.3%.

The next catalyst for share price gains?

One risk for the company is that another pandemic (or another major crisis) will hurt its civil aerospace revenue (which comprises 45% of its business). A major problem in one of its key defense sector products would also be very costly for it.

However, back in December, it had key performance forecasts for 2027. These included an operating profit of £2.5bn-£2.8bn, an operating margin of 13%-15%, and a return on capital of 16%-18%. . It is also aiming for free cash flow of £2.8bn-£3.1bn by then.

On 23 May, it said underlying operating profit could rise by up to 25% this year alone – to £1.7bn-£2bn.

It also said its civil aerospace unit could cut up to 110% of its pre-Covid flight hours this year.

It also underscored the importance of recently receiving the coveted investment grade rating from the three major credit rating agencies. This will give it more preferential access to capital, which can be used for further growth.

Would I buy it?

I already own the shares. BAE Systemswho works in the same sector, so adding someone else would make my portfolio unbalanced.

Additionally, having recently turned 50, I have been focusing on companies that pay dividends. Rolls-Royce currently does not. However, it has indicated that it will do so in the future as part of its new investment-grade company status.

That said, if I were even 10 years younger, and without other similar holdings, I’d buy the stock now.

It has a lot of growth potential and is still very undervalued in my view.

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