The question of whether or not the current Rolls-Royce (LSE: RR) share price is a bargain for 2022 and beyond depends on multiple factors. Some of these factors are out of the company’s control.
For example, suppose there is another coronavirus variant, which sets the world’s recovery back significantly. In that case, it could have a dramatic impact on Rolls’ ability to recover from the pandemic over the next few years.
However, if there are no unforeseen developments over the next few years, I think the corporation has potential.
Indeed, management has laid out some ambitious plans to increase free cash flow over the next couple of years. If it hits these targets, the Rolls-Royce share price could look cheap at current levels.
Two main catalysts
In my view, two main factors will be responsible for the performance of the Rolls-Royce share price over the next couple of years.
The first is the company’s cash generation. If management can hit targets over the next couple of years, then the group should be able to improve the state of its balance sheet and begin returning cash to investors.
This catalyst will depend on the overall recovery in the aviation industry. Rolls’ main income stream is from service contracts tied to engine sales. These contracts last for years after the engine is sold to the customer. The number of hours billed varies depending on the number of flying hours booked.
Therefore the more time an engine spends in the sky, the better it is for the firm’s cash generation.
This is why the most considerable risk facing the company is further pandemic restrictions. This would reduce flying hours booked by each engine and potential cash flow from service contracts.
According to the company’s latest trading update, the group returned to a positive free cash flow position in the third quarter of 2021. Management has said it expects the enterprise to report an overall free cash flow position of £750m during 2022.
Rolls-Royce share price valuation
Based on these numbers and factoring in the total shares outstanding for the enterprise, I calculate that the company can generate a free cash flow of around 11p per share in 2022.
Based on this target, the stock is trading at a forward free cash flow yield of 10%. To put that number into perspective, in 2018, the free cash flow yield was about 3%. To return to the same valuation, the Rolls-Royce share price would have to hit around 350p.
Of course, this is just the back-of-the-envelope calculation. It is only designed to estimate how much the stock could be worth in the best-case scenario.
As I tried to highlight above, any number of factors could destabilise the company’s recovery.
Nevertheless, looking at these figures, I think it is clear the shares are undervalued today, based on the corporation’s potential. As such, I would be happy to acquire the stock for my portfolio as a speculative recovery play.
Rupert Hargreaves has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
