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He Rolls-Royce (LSE:RR) share price continued to grow through 2024, achieving 100% growth in 12 months. As the company continues its transformation under CEO Tufan Erginbilgiç, analysts are optimistic about its prospects, citing strong earnings growth and improving profitability. In fact, from its lowest point about 26 months ago, it's hard to imagine how things could have gone better.
However, challenges such as high valuation metrics and market volatility could temper expectations. With key factors such as travel demand and defense spending playing a crucial role, the outlook for Rolls-Royce remains intriguing as investors weigh the chances of sustained momentum against potential valuation concerns.
Valuation concerns may not be justified
Concerns about Rolls-Royce's valuation may not be justified. While the company trades ahead of its long-term EV/EBITDA (enterprise value/earnings before interest, taxes, depreciation and amortization) ratio, this metric has been historically low due to past issues including efficiency and the pandemic.
Rolls-Royce has emerged from the recent challenges more cost-efficient and significantly deleveraged (with an improved debt position) and with strong prospects in its end markets. The company's successful turnaround and growth potential support a positive outlook among management, with analysts projecting continued strong EBITDA growth through 2026.
In other words, the company's fundamentals are solid and the business is growing. Free cash flow is also expected to continue growing, although at a slower pace than last year due to increased capital spending for long-term growth positioning.
Growth has a cost
As investors, we are typically willing to pay a premium for companies that promise to grow earnings. Sometimes that premium can be a little extreme. Arms, Broadcomand tesla These could be examples of cases where the growth premium is simply too high.
However, Rolls-Royce's growth-oriented metrics are much more palatable. The stock currently trades at 35 times forward earnings, but the company is expected to grow earnings annually by 30% over the medium term. This gives us a price-earnings-growth (PEG) ratio of 1.18.
This PEG ratio may be above one's traditional fair value benchmark, but valuation metrics are always relative. It is cheaper than its peers and Rolls operates in sectors with very high barriers to entry.
Taking these factors into account, a peer group valuation suggests the stock is trading 30% to 50% below its peers based on projected earnings over the next two years. This indicates that current valuation concerns may be overstated, considering Rolls-Royce's improved fundamentals and future growth platforms.
The final result
Investors should be cautious with Rolls-Royce due to ongoing aerospace supply chain challenges affecting working capital efficiency, production and deliveries of new aircraft. These issues can potentially reduce engine flight hours and impact the company's long-term service agreement business.
Despite this, management and analysts remain confident in the company's ability to continue generating growth and value for investors. If the company continues to beat expectations for quarterly growth, I expect it to rise. If I didn't already have healthy exposure to this engineering giant, I would consider buying more.
