Image source: Rolls-Royce Holdings plc
Rolls-Royce (LSE:RR.) The shares have been a strong performer among FTSE 100 shares in 2023. Having risen a staggering 144% in less than a year, potential investors could be forgiven for wondering if Rolls-Royce’s share price is now quite expensive.
However, despite trading near a 52-week high, the stock is still 17% below where it was five years ago. Long-term shareholders will hope the aerospace and defense giant’s post-pandemic recovery continues to move forward. After all, at £2.41 today, the share price is still well below the all-time high of £4.42 it reached in 2014.
So, let’s take a closer look at Rolls-Royce’s investment prospects today.
Valuation
First, it makes sense to address the issue of valuation head-on.
Since the company generates almost 47% of its revenue from the delivery and maintenance of civil aircraft, it suffered greatly during the pandemic due to strict travel restrictions. During this period, Rolls-Royce was a loss-making company.
Therefore, I think it is more insightful to look at the company’s price-to-sales (P/S) ratio, rather than the more widely used price-to-earnings (P/E) ratio, to gauge its current valuation.
As the chart above shows, Rolls-Royce shares are currently more expensive, by this metric, than at any time in the last five years.
Consequently, value investors may have legitimate concerns that the company will struggle to generate similar returns in 2024 compared to the last 12 months.
Net debt
On the balance sheet, Rolls-Royce has made good progress in reducing the mountain of debt it accumulated during the pandemic. In the first half of 2023, this figure improved to £2.75 billion, after having soared to £5.1 billion at the end of 2021.
All major credit rating agencies now have a positive outlook on Rolls-Royce. That said, the group has yet to earn an investment grade rating again.
| Agency | Credit rating |
|---|---|
| Moody’s | Aa3 |
| Fitch | BED AND BREAKFAST- |
| S&P | BED AND BREAKFAST |
Free cash flow
I would like to see the company generate stronger cash flows in the coming years as it has recently curbed its outflows, but the trajectory looks encouraging. This could translate into rating improvements in the future.
CEO Tufan Erginbilgic acknowledged that the company was slow to respond to the inflationary environment with price increases for its services.
This could bode well for future cash flow improvements. Rolls-Royce arguably has room to capitalize on its competitive advantages and raise prices further.
Cost effectiveness
Lastly, diluted earnings per share (EPS) are almost back to pre-Covid levels.
This crucial profitability metric is the number that really catches my attention. It tells the story of Rolls-Royce’s remarkable turnaround under Erginbilgic’s leadership.
A stock to buy?
It’s fair to say that Rolls-Royce’s share price growth over the past year has been nothing short of spectacular.
The continued recovery in civil aviation flying hours, lucrative submarine deals arising from the AUKUS defense pact and innovative technology for small modular nuclear reactors add weight to the investment case.
However, shares are not as cheap as before. Investors would do well to limit their expectations if they take positions today. However, I am a shareholder and will continue to maintain my position with the prospect of possible dividend restorations on the near horizon.
