2 reasons why Rolls-Royce shares could take off!

Since August 2022, the value of Rolls-Royce Holdings (LSE:RR.) shares has soared by more than 1,200%. With all the hype surrounding the Magnificent 7 and the impact of artificial intelligence, it’s easy to overlook this remarkable performance. After all, Nvidia’s stock price has increased by ‘only’ 980% over the same period.

Looking to the future

We are told that share prices reflect the discounted future cash flows of a business. The consensus of analysts is for Rolls-Royce to have free cash flow of £4.49bn in 2028. With a current (20 August) stock market valuation of £89.3bn, it means the group’s shares trade on 19.9 times this figure.

Forecasts rarely look further ahead than three or four years. There are too many moving parts for predictions to be meaningful beyond this period. It’s therefore probably not a coincidence that this is also the average length of time that investors hold a particular stock. A 2023 survey by The Investment Association found that 3.6 years is typical. Calastone says the average holding period is now four years, down from seven years in 2016.  

Why is this relevant to the Rolls-Royce share price?

Well, if investors are planning to hold a stock for only four years, it stands to reason that they aren’t looking at the aerospace and defence group’s prospects beyond 2029. And yet the 2030s could be transformational for the group. This is when two new earnings streams might emerge.

Going nuclear

The first involves small modular reactors (SMRs). These are factory-built mini nuclear power stations. I’ve seen one forecast suggesting that 700 will be needed by 2050. If Rolls-Royce sold (say) five each year for £2.2bn each at a 15% margin, it would add £1.65bn to its bottom line. Assuming this translated into cash, at a multiple of 19.9, it could add over £32bn to the group’s value.

But the technology is still unproven. Although two SMRs exist – in China and Russia – they are not operating commercially. There are dozens of different designs using alternative cooling methods that are currently being assessed. Nobody knows which (if any) are likely to succeed.

Flying higher

The second new opportunity is the supply of engines to the narrowbody aircraft market. By 2032, this could be worth $150bn a year. If the group captured 15% of this (it’s believed to have one-third of the widebody market) at a 20% margin, it could generate $4.5bn (£3.3bn) of profit a year. If this converted into free cash, it could add another £62bn to the group’s market cap.

But it’s never easy entering a new market, especially one where long-standing relationships exist between aircraft manufacturers and suppliers. And the pandemic highlighted how vulnerable the sector can be to disruption.

Also, the situation is a little more complicated than this. The majority of engine revenue is earned over a period of many years and a similar model might be adopted for SMRs. However, both have the potential to take the group’s financial performance to another level. If these two revenue streams could add close to £100bn to the group’s stock market valuation over the next decade, I don’t see why its share price couldn’t double.

For this reason, Rolls-Royce stock could be one for long-term investors — those looking more than four years ahead — to consider.