Image source: Rolls-Royce plc
Lately, the actions of Rolls-Royce (LSE: RR) have been hovering around £4. For investors who bought them for less than a tenth of that price in 2020, that's an incredible increase in value.
Aerospace engineer was the best performing stock in the FTSE 100 index last year. So far this year, Rolls-Royce shares are up a third again.
But is Rolls-Royce really worth 10 times more than it was four years ago? Or are the stocks now overvalued?
How to value Rolls-Royce
There are different ways to value companies. For a mature company like Rolls-Royce, a common ratio is the price-to-earnings (P/E) ratio.
In isolation, a P/E ratio doesn't tell the whole story. It is also important to consider aspects such as a company's balance sheet, for example. Rolls has been cutting its debt, but still had £2bn of net debt at the end of last year.
Still, a P/E ratio can be useful. The reason many investors like it as a valuation metric is its simplicity. Basically, it indicates how many years it would take a buyer to pay off the cost of buying a company outright, using its earnings at their current level.
In practice, things can be more complex. Bid premiums, debt costs, and fluctuating earnings mean that if I bought a company with a P/E ratio of 10 (for example), I may not actually be able to finance my purchase simply by using the next decade of its Profits.
But the metric can be a useful criterion. The lower it is, the cheaper a stock is generally considered to be.
P/E ratio seems reasonable
At the moment, the P/E ratio for Rolls-Royce stock is 13. That seems reasonable to me. I don't see it as a bargain, but rather a fair price for the company with its proprietary technology, large installed customer base, and strong sales pipeline.
That P/E ratio is based on statutory basic earnings per share. Last year, underlying earnings per share were less than half the statutory equivalent, meaning that on that basis the P/E ratio would be closer to 30. However, I prefer the statutory earnings per share basis, since in general I think it reflects more accurately. a company's actual performance compared to underlying earnings per share.
Rolls has announced aggressive medium-term plans that should grow earnings per share if successful. On that basis, the forecast P/E ratio could reach high single digits. So even though Rolls-Royce shares have soared, they don't necessarily look overvalued to me.
What comes next?
But for now, those goals are just goals. Rolls, a company with a long history of significant changes in profits from year to year, has to prove it can deliver.
If so, I consider the current price to be fair and perhaps even cheap.
But, in my opinion, it offers me little margin of safety as an investor if profits do not grow as expected. That could happen due to risks outside the company's control, such as a sudden slowdown in civil aviation demand due to a pandemic or a terrorist attack. We have seen this repeatedly before.
On that basis, I will not be buying Rolls-Royce shares.
