I think it’s fair to say that despite its recent stellar run, many investors still think the Rolls-Royce (LSE:RR.) share price offers some value. However, in my opinion, some of the analysis I’ve read (not written by my fellow Fools, I hasten to add) is flawed.
I’ve seen one justification for buying Rolls-Royce shares that went something like this: although the stock’s currently expensive, in a few years’ time — assuming earnings grow in line with forecast — today’s share price will have looked like a great entry price. Therefore, the argument goes, now’s a good time to invest.
To support their point of view, the author quoted future earnings forecasts compiled by brokers.
Taking a long-term view
These show that for the year ending 31 December (FY24), analysts are expecting earnings per share (EPS) of 15.8p. Based on a current (5 July) share price of 462p, it means the stock trades on a forward price-to-earnings (P/E) ratio of 29.2.
This is comfortably above the FTSE 100 average of around 10.5. That’s why many investors consider the stock to be overvalued.
However, for FY27, EPS of 26.5p is anticipated. If this is accurate, the P/E ratio drops to a more sensible 17.4. This is still above the Footsie average, but not unreasonable for an engineering firm.
In other words, the stock looks expensive today but it won’t be in 2027.
| Financial year (31 December) | Forecast EPS (pence) |
|---|---|
| 2024 | 15.8 |
| 2025 | 19.1 |
| 2026 | 22.6 |
| 2027 | 26.5 |
Am I missing something?
But, in my opinion, this argument doesn’t make sense.
If a P/E ratio of 17.4 is a fair valuation for Rolls-Royce then its share price will be the same in 2027 as it is today. That’s because 17.4 multiplied by its FY27 EPS (26.5p) gives a share price of 462p. This is the same as its current value — P/E ratio (29.2) x FY24 EPS (15.8p) = 462p.
That doesn’t sound like a very good investment to me.
| Period | EPS (pence) | P/E ratio | Share price (pence) |
|---|---|---|---|
| FY24 | 15.8 | 17.4 | 275 |
| FY24 | 15.8 | 29.2 | 462 |
| FY27 | 26.5 | 17.4 | 462 |
| FY27 | 26.5 | 29.2 | 774 |
And what happens if we turn the argument on its head? Let’s assume a multiple of 17.4 is fair. Based on its 2024 earnings forecast, the company’s shares should currently be changing hands for 275p — 17.4 x 15.8p. This is approximately 40% lower than their present level — and supports the theory that they’re overvalued.
Final thoughts
My analysis holds true as long as investors behave rationally and believe a multiple of 17.4 to be reasonable. However, if the elevated P/E ratio of 29.2 is maintained through until 2027, the company’s shares will be worth 774p each — a 67% premium to today’s value.
But I think investors do act rationally. And that the majority will soon believe that its shares should be valued closer to a multiple of 17 than 29. That’s why I suspect the Rolls-Royce share price rally will soon run out of steam.
Don’t get me wrong, I’m a fan of the company. I think it has a great reputation and has recovered strongly from the pandemic. I also think its development of small modular reactors — factory-built nuclear power stations — could be highly lucrative.
However, I think there are better value opportunities available elsewhere at the moment, including stocks that pay a generous dividend. I’m therefore not going to invest.
However, I will sit back and watch with interest where the Rolls-Royce share price goes next.
This post was originally published on Motley Fool
