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Rolls-Royce (LSE:RR) shares have soared in 2023. However, at current prices of 242p, they could still be considered a FTSE 100 negotiate.
Well, the engine maker’s price-to-earnings (P/E) ratio of 25.2 times for this year isn’t all that impressive. It sails above the 12x forward average for FTSE-listed shares.
But in terms of price-earnings growth (PEG), Rolls stock looks ultra-cheap. A forward-looking reading of 0.1 is well below the benchmark of 1, suggesting the company is severely undervalued by the market.
Profits boom
PEG is the preferred metric among many investors as it considers projected earnings growth. And here, City analysts expect the bottom line to rise by an impressive 375% year-on-year in 2023.
This is not everything. Earnings are expected to grow by about a quarter year-over-year over the next two years. Therefore, its PEG multiple remains below the value criterion of 1 (at 0.9 and 0.8 for 2024 and 2025, respectively).
Strong demand in its end markets, combined with strong results from its transformation strategy, are boosting earnings considerably. However, the company still has significant obstacles to overcome. So, should I buy cheap Rolls-Royce shares for my portfolio?
The case for
One reason I would invest is that, despite continued pressure on consumer wallets and a faltering global economy, the aviation industry remains in fairly good health.
In recent days united airlines, Ryanair and Singapore Airlines They have all posted important trading updates. This is critical news for Rolls given that its Civil Aerospace division is responsible for generating almost half of all revenue.
Meanwhile, the noise coming from the defense sector – another key area for the London company – is also very encouraging. BAE Systems announced in recent days that it has racked up another £10bn worth of orders since mid-2023.
Finally, new CEO Tufan Erginbilgiç remains committed to aggressive transformation and in October announced the elimination of an additional 2,000 to 2,500 jobs. The above rationalization already boosted its balance sheet and gave a big boost to cash flows.
The case against
But as we approach 2024, there are big risks to Rolls-Royce’s profits and its share price.
As I say, the civil aviation market has remained largely strong. But some chinks in the armor (like fresh air(last week’s earnings guidance cut) have emerged that suggest the tide may be turning. Continued strains on the global economy, coupled with rising airline fuel costs, pose a huge risk to the recovery.
Rolls also faces problems elsewhere. Signs of stress have emerged in its Power Systems division, an area where orders fell 14% in the first half. Elsewhere, supply chain issues continue to reverberate throughout the company, while cost inflation remains high.
Finally, the company still has considerable net debt (which amounted to £2.8bn) as of June. And a large amount of its loans will need to be repaid before the end of 2025.
The verdict
While there are things to like about Rolls-Royce, I also fear that a bubble has formed around the stock following the huge share price gains. Given the problems the company still has to overcome, I prefer to buy other cheap UK shares today.
