The Rolls-Royce (LSE:RR.) share price bull run shows no sign of slowing down. The stock’s currently (1 November) changing hands for 144% more than it was 12 months ago. This performance defies the critics who claim that the group’s overvalued. But is it?
There are a number of ways of assessing whether a stock offers good value. The most common is the price-to-earnings (P/E) ratio.
For the year ending 31 December 2024 (FY24), analysts are forecasting earnings per share (EPS) of 18.7p. This means the stock’s trading on a forward earnings multiple of 28.8.
This is over twice the average of the FTSE 100. And it makes me think the group’s shares aren’t particularly cheap.
But wait …
However, others are more expensive.
For example, the forward P/E ratio of the Magnificent Seven in the US is 35.
But is it right to compare Rolls-Royce with seven of the largest tech companies on the planet? Maybe. To me, the group appears to combine engineering excellence with cutting-edge technology.
Technology stocks are likely to sustain a higher valuation for longer. Nothing’s guaranteed but investors are generally prepared to pay a higher premium for a company that has the potential to deliver above-average revenue and earnings growth.
And if the analysts are correct, Rolls-Royce look set to deliver an impressive financial performance over its next three financial years.
They’re forecasting EPS of 21.9p (FY25), 25.6p (FY26) and 29.3p (FY27). If these estimates prove to be accurate, the stock’s currently trading on 18.4 times its 2027 earnings.
And by the end of that year, the group will have grown its earnings by 56.7%.
On this basis, the stock looks to be reasonably valued.
However, if there’s any sign that it isn’t going to meet these targets, its share price will suffer. Recently, it wobbled when Cathay Pacific reported a problem with one of its engines.
And another pandemic cannot be ruled out. The last one nearly destroyed the company.
Another option
An alternative way of assessing shares is to use the price-to-earnings growth (PEG) ratio. This is calculated by dividing a stock’s current P/E ratio by the expected growth rate in its EPS.
Applying this to Rolls-Royce gives a PEG ratio of 0.5. This is below one which suggests it offers good value. This could explain why it appears to remain a favourite with investors.
However, those looking for generous levels of passive income are likely to be disappointed. The company’s expected to pay a dividend of 5p a share this year, implying a current yield of 0.9%.
But investors generally don’t buy growth stocks for their dividends. They expect surplus cash to be reinvested, developing new products and coming up with clever solutions that’ll increase earnings.
The yields of the Magnificent Seven currently vary between 0% and 0.7%. And these miserly returns don’t appear to have affected their stock prices too much.
My opinion
Based on the group’s growth prospects, I think it’s fair to say that the Rolls-Royce share price still offers some value.
It might not be the cheapest stock on the FTSE 100 but if it can deliver the anticipated growth in revenue, free cash flow and earnings, I don’t think it’s too late to invest.
That’s why I recently took a position.
This post was originally published on Motley Fool
