Are Rolls-Royce shares still woefully mispriced? The DCF model suggests so!

Six months ago, Morgan Stanley explained Rolls-Royce (LSE:RR) shares are “wrong price”. The bank said the recovery in earnings was “closer to market value, while direct earnings and cash flow are directed towards the next step in the global aviation recovery“.

At the time, the shares were trading for 95p. It is currently priced at 91p. So was Morgan Stanley wrong, or did investors just miss an opportunity?

Is Rolls-Royce cheap?

It is important to remember that a stock that is cheaper than before does not necessarily mean that it is cheap. And Rolls-Royce shares fell 23% in one year, and 62% in three years.

But it illustrates the challenges the company has faced. It typically derives the majority of its revenue from the civil aviation segment and engine flight hour contracts. The company took on more debt during the pandemic and has sold business units to pay off the debt.

However, there are some metrics that we can look at to find out if the stock is really undervalued. Near-term metrics show that the company is underperforming its peers.

As you can see, in many cases, the metrics show that Rolls is trading at a discount to its peers.

A discounted cash flow (DCF) model often provides more clarity, but I need to make an estimate of future cash flows.

This model may take some time to calculate. However, thankfully, some experts have shared the DCF calculation for Rolls-Royce.

One DFC with out five years suggests that FTSE 100 The stock is overvalued by 5.8%. That’s not good to hear as an investor. However, compared to other stocks in the sector, Rolls is not expensive.

Analysts suggest that competitors Rolls has been overvalued, on a five-year basis, between 14.4% and 48.9%.

However, DCF with exit in 10 years suggests Rolls undervalued by 49.6%. That’s really enough. Analysts estimate the share price range for the 10-year exit is from 88.8p to 238p. The chosen figure is 136p.

Pros vs cons

Rolls still has £4bn in debt obligations – all on fixed interest rate terms – maturing between 2024 and 2028. That will be a drag on profitability. And in the near term, civil aviation has not fully recovered to pre-pandemic levels.

In the last update, Rolls said that the hours spent by customers are currently at 65% of the level of 2019. However, the opening of the Chinese economy should increase. The president of Emirates airline recently said that when the Covid restrictions in China are lifted, the country will “unleash the demand, the likes of which we will not see for a long, long time“.

Combine this with strong performance in the other two segments, power systems and defense, and I believe Rolls will be well on its way to 2023 and beyond. This is why I buy more.