Image source: Rolls-Royce plc
Despite being the best-performing FTSE 100 stock of 2023, Rolls-Royce (LSE:RR) shares might still be undervalued. That’s the view of analysts at Bank of America (BoA) anyway.
I think they might well be right. But I have my own reasons for thinking the stock is a bargain that are quite different to theirs.
A rising share price
After a standout performance in 2023, it’s hard to imagine the Rolls-Royce share price being a bargain. When the price of anything triples in 12 months, many would fail to see it as a bargain.
The fact a stock is up doesn’t mean it’s not cheap though. Between 1997 and 2000, the Microsoft share price increased 450%, but anyone who bought shares 24 years ago made a great investment.
I’m not saying Rolls-Royce is set for that type of return. I do think though that investors shouldn’t stay away from the stock just because it’s more expensive than it used to be.
It can be hard to buy a stock at £3, having seen it at £1 not so long ago. And it can be tough for anyone who is up 200% not to sell their shares. But overcoming those difficulties is the key to investing well.
Bank of America
Analysts at BoA think there might be more to come from the stock. This is partly because it currently trades at a discount to others in the sector, despite outperforming them in 2023.
They’re right about this – in terms of price-to-earnings (P/E) ratios. French outfit Safran trades at 21 and German manufacturer MTU trades at 22. Rolls-Royce trades at around 15.
I’m not convinced this means Rolls-Royce shares are undervalued though. They might be cheap compared to the rest of the sector, but I think it’s possible the sector as a whole is overvalued.
In fairness, this isn’t the only reason BoA cites for thinking that the stock is undervalued. But it’s a part of the picture that I don’t think is particularly convincing.
Cash flows
The real reason I think Rolls-Royce shares might be undervalued is the company’s future prospects. The firm has set a target of generating £3.1bn in free cash in 2027.
A price of £24.8bn today leaves a margin of safety even if that doens’t quite come off. And as BoA’s analysts rightly note, there are some important catalysts coming through.
The firm is in the process of improving its balance sheet, which should help with profitability. Right now, around 43% of operating income goes on paying interest on its debts.
A stronger balance sheet should lead to an improved credit rating which, in turn, should bring down interest costs. And that’s set to happen in 2024, boosting profitability in the near term.
Should investors consider buying Rolls-Royce shares?
Despite an outstanding performance in 2023, I can see how Rolls-Royce shares might still be undervalued. The stock trades at a price that looks cheap, given the company’s ambitions.
But I’d be wary of comparing the stock’s trading multiples with others in the same sector. That might say more about them than it does about Rolls-Royce.
