Rolls-Royce (LSE: RR) shares have risen a long way from their 23 October 12-month traded low of £1.97. But as it consolidates its position in the elite investment grade of companies, I think it may well go higher over time.
However, I already have a holding in BAE Systems (LSE: BA) that operates broadly in the same business space.
To own both might unbalance the risk-reward profile of my stock portfolio. So, which one looks best for mw to own right now?
Relative valuations
On the key price-to-earnings (P/E) stock valuation measurement, Rolls-Royce trades at 17.9. BAE Systems is at 20.7.
Both firms occupy the bottom two spots in their competitor group, which has an average P/E of 43.3. So, both look very cheap on that basis.
A discounted cash flow analysis shows Rolls-Royce to be 54% undervalued at its present price of £5.25. BAE Systems is 23% undervalued at £12.75.
Therefore, a fair value for Rolls-Royce shares would be £11.41, and for BAE Systems £16.56. Both could go lower or higher, given the vagaries of the market, of course.
Nonetheless, a win here for Rolls-Royce, I think.
Revenue and earnings prospects
A company’s share price (and dividend) are ultimately driven by rises in revenue and earnings. Revenue is the total money a firm receives, while earnings are the money left after expenses and tax.
Consensus analysts’ estimates show a major difference between the two firms’ prospects in one key regard to 2027.
Revenues at both are expected to climb: up 5.5% a year at Rolls-Royce and up 8.7% annually at BAE Systems.
But earnings at Rolls-Royce are expected to fall to end-2027 (albeit by just 0.09% a year), while BAE Systems’ are forecast to rise 7.3% annually.
A risk to Rolls-Royce is that its production capabilities do not keep up with its fast sales growth. This could lead to costly failures in products.
For BAE Systems, a risk is poor management of its foreign exchange exposure, given its huge international order book. This could produce big currency losses on market fluctuations.
Overall, though, a win here for BAE Systems, in my view.
Dividend yield generation
BAE Systems paid a total dividend in 2023 of 30p a share. This gives a yield on the current £12.75 share price of 2.4%.
Analysts predict this will increase to 2.8% in 2025 and 3.1% in 2026.
Rolls-Royce currently pays no dividend but says it will introduce one this year. Analysts expect a 1.1% yield in 2025 and 1.6% in 2026.
So, a second win – and overall victory – for BAE Systems.
Which would I buy?
My holding in BAE Systems was built up over many years at a much lower average price than today’s. So, I am extremely content with this position.
That said, I would happily buy it today if I did not already own it. It has tremendous growth prospects in a strongly expanding sector, I think. And it also pays a reasonably decent dividend as well.
Nevertheless, I am a big fan of Rolls-Royce too. It also benefits from the burgeoning defence sector and should continue to do well, I think.
However, I would not have two stocks in the same sector at present, and BAE Systems is still my number one choice in the field.
This post was originally published on Motley Fool
