Image source: Getty Images
If you follow Rolls-Royce (LSE:RR) shares closely, you’ll know they’re pretty expensive. I don’t mean they’re expensive because they’re £12.50 each rather than the 70p they were three years ago. I mean they’re expensive on conventional valuation metrics.
Valuation metrics are the most important method of understanding whether a stock is a good investment or not. I don’t think it should be based on some notion or principle like “I think migration will drive housing prices up and therefore house builders are a good shout”.
One of the core metrics is the price-to-earnings (P/E) ratio. And this is one that is easily applied to an industrials stock like Rolls-Royce. The stock trades at 38.9 times forward earnings, a huge premium to the sector average, which is around 22.5 times.
Of course, this is just a starting point. Let’s explore.
Already so expensive
A high P/E ratio — the forward ratio is always more telling than the trailling figure — tells us a bit about the valuation, but not everything. It needs to be combined with forecasts on earnings growth, dividends, profitability, and the balance sheet.
Firstly, Rolls has a perfect balance sheet. The company’s net cash position is around £1.1bn, which is great. It’s not a huge figure given this is a £106bn-company, but it’s far better than a net debt position.
Then there’s profitability. Operating margins have been improving and currently sit around 20.6%. That’s above the industry average and a testament to the company’s pricing power.
And then there’s growth. Analysts forecast that earnings will grow around 18.7% per year on average over the medium term. We can combine that figure with the forward P/E to reach a price-to-earnings-to-growth (PEG) of 2.1.
Now, the PEG ratio — a favourite of mine — is a growth-adjusted valuation. Traditionally, a ratio below one was a signifier of good value. At 2.1, Rolls looks overvalued, but it does have a great balance sheet and it’s clearly a quality company — strong margins and moats.
The dividend yield sits below 1% and probably isn’t worth thinking about.
In short, this suggests that Rolls shares won’t go much higher because they’re already expensive.
The wildcard
One potential wildcard for Rolls-Royce shares is its small modular reactor (SMR) programme.
The division currently generates no material revenue, meaning it contributes little to the group’s roughly £20bn annual sales base, which is now firmly underpinned by a fully recovered civil aerospace business, alongside defence and power systems.
As a result, SMRs remain largely excluded from near-term earnings models and valuation frameworks.
That said, forecasts point to meaningful long-term potential. Rolls-Royce estimates global demand for hundreds of SMRs by mid-century, while external analysts suggest the nuclear business could ultimately be worth around £10bn.
In theory, this could happen in the next 10-15 years. Coupled with steady growth in existing verticals, total revenue could feasibly reach £40bn-45bn per year.
Because expectations are low today, any tangible progress on approvals, funding, or contracts could re-rate the stock disproportionately,.
So, in theory, and applying a consistent price-to-sales ratio, there absolutely is scope for the stock to trade near or above £20 per share. However, there are so many moving parts here and SMRs will undoubtedly be priced in to some extent already.
Personally, I think the stock is worth considering, but better value can be found elsewhere.
This story originally appeared on Motley Fool
