Image source: Rolls-Royce plc
Investors who put £11,000 – the average UK savings amount – into Rolls-Royce (LSE: RR) shares a year ago have done very well indeed.
That would have secured 2,600 shares in the firm at the 13 May 2024 opening price of £4.23.
At today’s (13 May) opening price of £7.83 those shares are valued at £20,358. A 6p dividend was also paid, adding another £156 to the pot to make £20,514.
This gives a total return over the year of £9,514 — a profit of over 86%!
I bought some of the shares just after they had dipped following the 2 April announcement of US tariffs.
So I am more than idly wondering whether this sort of performance can be repeated in the coming year. I took a closer look to find out if this is likely.
Can it still be undervalued?
It is a common misconception that little further profit potential can remain in a stock after such a big price rise.
This is untrue and is founded on the mistaken assumption that price and value are the same thing. They are not, as my experience as a senior investment bank trader and longtime private investor has taught me.
To begin to differentiate the two, I compared Rolls-Royce’s key stock valuations with its competitors. Its 26 price-to-earnings ratio looks very undervalued against its competitors’ average of 33.5 to start with.
These comprise Northrop Grumman at 19.1, BAE Systems at 27.3, RTX at 37.3, and TransDigm at 50.2.
It also looks very undervalued on a price-to-sales ratio of 3.5 against its peer group’s average of 4.
Next I looked to pinpoint where its share price should be, based on future cash flow estimates for the firm. Incorporating other analysts’ figures and my own, the resultant discounted cash flow analysis shows Rolls-Royce shares are 40% undervalued at their present price of £7.83.
Therefore, their fair value is £13.05, although share price moves are unpredictable.
How does the core business look?
A risk to the firm remains the increasingly protectionist US, in my view. Tariffs might be increased, for example.
However, the company clarified that it has major operations in 27 US states that provide it with extra supply and production capacity in-country. It said it will use this “to ensure our global internal supply chain is optimised for delivery to customers in the US”.
In its 1 May trading update, it reiterated its 2025 guidance of £2.7bn-£2.9bn in underlying operating profit. This compares to £2.5bn in 2024 and £1.6bn in 2023.
It also forecasts £2.7bn-£2.9bn of free cash flow against £2.5bn in 2024 and £1.3bn in 2023.
Both these can be powerful engines for further growth, in my experience.
In its aerospace business, the Airbus A350-900 with Rolls-Royce’s new Trent XWB-84 EP engine variant was certified in April.
In defence, April also saw delivery of its first AE 3007N engine to Boeing for the US Navy’s aircraft carrier-based drone programme.
And in its power operations, March saw the Czech Republic’s ČEZ Group make a major strategic investment in its small modular reactors segment.
I believe Rolls-Royce has enormous earnings growth potential from here in the coming years. This should drive its share price much higher over time and allow for it to increase its dividends too.
Therefore, I will be buying more of the stock very soon.
