Rolls-Royce shares are still cheap despite the recent rally

Rolls-Royce (LSE: RR) shares have been among the strongest performers in the FTSE 100 in the last month. The stock is currently up 33% over the last quarter, but down 10% over the past 12 months. However, despite the recent public meeting, I still believe that the engineering giant is undervalued. Let’s explore why.

Evaluation

The stock is described as “precious” by Morgan Stanley end of summer. The bank said that the recovery of its income “closer to market value, while direct earnings and cash flow are directed towards the next step in the global aviation recovery“.

Since then, the stock has gained around 15%, but the evidence suggests that there is still more to go.

To begin with, short-term metrics suggest the company is underperforming its peers.

As we can see, according to some metrics, Rolls seems to be cheaper than its peers.

These findings are generally substantiated by the discounted cash flow (DCF) model. The DCF model is based on the idea that the value of a company is determined by how well it can generate cash flow for investors during the investment.

A calculation of DCF with exit in 10 years suggests Rolls undervalued by 27%. The analysis showed a share price range of 88.8p to 238p, and a fair value of 136p.

Collectively, these valuation metrics suggest that Rolls remains undervalued in its current position. This is a core part of the investment decision making process.

Reasons for optimism

Rolls has faced some significant challenges in recent years. Civil aviation, its bread and butter, accounts for more than 40% of total revenue. After a period of crisis caused by the pandemic, this segment is now growing again.

The company produces aircraft engines, mainly for wide body aircraft like Airbus A350 and Airbus A330neo. These planes tend to be used for long-haul flights, and this is an area where recovery is slower. But 2023 looks different, especially when China reopens. Wide-body aircraft tend to be used on domestic flights in China.

Looking at defense, the company’s second-largest sector, analysts generally agree that the war in Ukraine means greater defense spending in the coming years. In 2021, it won a $2.8bn contract for B-52 bombers from the American government, and in 2022 it secured a deal of up to $6bn for the next generation of US rotary aircraft.

Analysts have also tipped the new UltraFan engine to be a game-changer for the firm. The 140-inch diameter power unit can produce 64MW of power. May run on 100% Sustainable Aircraft Engine Fuel (SAF) from day of service. SAF is less polluting than regular fuel.

Risk

When I bought more Rolls shares, I had to understand the risks. Debt is one of the challenges they face. Rolls still has £4bn in debt obligations – all on fixed interest rate terms – maturing between 2024 and 2028. Fixed term rates are certainly positive for the firm, but the burden is likely to impact profitability going forward.