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I Rolls-Royce (LSE:RR) share price continued to grow until 2024, delivering 100% growth within 12 months. As the company continues its transformation under CEO Tufan Erginbilgiç, analysts are optimistic about its prospects, citing strong earnings growth and improved profitability. In fact, from its lowest point nearly 26 months ago, it’s hard to imagine how things could have gotten any better.
However, challenges such as high valuation metrics and market volatility can dampen expectations. With key factors such as travel demand and defense spending playing a key role, Rolls-Royce’s outlook remains impressive as investors weigh the potential for continued momentum against potential analytical concerns.
Estimating concerns may not be possible
Concerns about Rolls-Royce’s valuation may not be justified. While the company is trading ahead of its long-term EV-to-EBITDA ratio (enterprise value to earnings before interest, taxes, depreciation, and amortization), this metric has been historically low due to past issues, including efficiency and the pandemic.
Rolls-Royce has emerged from the recent challenges of being more frugal and much reduced – having an improving credit situation – with strong prospects for its end markets. The company’s successful transformation and potential growth support the positive outlook among management and analysts predict continued strong EBITDA growth until 2026.
In other words, the company’s fundamentals are strong and business is growing. Free cash flow is also expected to continue to grow, albeit at a lower rate than last year due to higher long-term capital growth costs.
Growth comes at a very high rate
As investors, we are often willing to pay for companies that promise to increase profits. Sometimes, that premium can be a little excessive – Arm Holdings, Broadcomagain Tesla would be examples of where the growth premium is too high.
However, the growth-oriented metrics at Rolls-Royce are more palatable. The stock currently trades at 35 times forward earnings, but the company is expected to grow annual revenue by 30% over the medium term. This gives us a price-to-earnings-growth (PEG) ratio of 1.18.
This PEG ratio may be above the common fair value benchmark of one, but the analytical metrics are always relative. It’s cheaper than peers, and Rolls operates in sectors with very high barriers to entry.
Given these factors, the group’s peer rating suggests the stock trades between 30% and 50% below its peers based on forecasted earnings for the next two years. This indicates that current valuation concerns may be overstated, given Rolls-Royce’s improved fundamentals and future growth platforms.
An important point
Investors should be cautious about Rolls-Royce due to the ongoing challenges of the aerospace supply chain affecting the efficiency of working capital, output, and delivery of new aircraft. These issues may reduce engine flight hours and impact the company’s long-term service contract business.
Despite this, management and analysts remain confident in the company’s ability to continue to deliver growth and value to investors. If the company continues to exceed quarterly growth expectations, I would expect it to go higher and higher. If I didn’t have healthy exposure to this developer giant, I would consider buying more.
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