‘Fair value’ is a term used to describe what a share is really worth. It’s usually estimated by looking at the expected future cash flows of a business and expressing them in today’s money.
So what could this tell us about the current (10 July) price of Rolls-Royce Holdings (LSE:RR.) shares? Let’s take a closer look.
A bit of number crunching
The starting point for a discounted cash flow (DCF) calculation is a company’s free cash flow (FCF), typically defined as the cash generated from its operating activities after taking into account capital expenditure, loan and lease repayments.
With its relatively high margin and repeat business from its aircraft engine division, Rolls-Royce is particularly strong when it comes to generating cash. Analysts have a consensus target over the next three years as follows:
- 2026 = £3.734bn
- 2027 = £4.438bn
- 2028 = £5.150bn
If these forecasts prove correct, the group’s FCF will be 57% higher in 2028 than it was in 2025. That’s an annual growth rate of approximately 16%. Personally, I think it’s unlikely that this will continue indefinitely. I’m therefore going to assume that it drops by half (to 8%) after five years.
To come up with a fair value, we also need to consider an appropriate discount rate to reflect the fact that £1 tomorrow is worth less than £1 today. There have been plenty of university papers written about how this should be calculated. Typically, a company’s weighted average cost of capital is used. For Rolls-Royce, this is estimated to be 10.5%.
What next?
Plugging these numbers into a simple spreadsheet (there are plenty of examples available online) tells me that a fair value for Rolls-Royce is £171bn, which is 38% higher than its current market cap. This looks promising. That’s because, in theory, share prices move towards a company’s fair value over time.
However, DCF calculations come with a huge health warning. They’re very sensitive to the assumptions made and crucially, rely on forecasts that are difficult to prepare accurately.
So let’s take a step back from the numbers and consider the investment case.
My view
For its long-term growth potential, I reckon Rolls-Royce is a stock to consider. That’s because I see many factors that will help each of its divisions grow over the coming years.
Air passenger numbers are rising, which should increase the number of hours that its engines are flown.
Data centres will need more power than the grid can provide so demand for the group’s on-site solutions should rise. Looking further ahead, small modular reactors could be the answer to this infrastructure deficit.
Also, its defence business is likely to benefit from increased geopolitical uncertainty.
Of course, the aviation sector is vulnerable to rising fuel costs and a Covid-like shutdown. Also, having performed strongly since the pandemic, the group’s share price could suffer if there’s any sign of a slowdown in the group’s performance, including the possibility that it will miss the impressive FCF forecasts referred to earlier.
However, I’m optimistic about Rolls-Royce’s prospects. It’s a high-quality business with an excellent reputation. That’s why I have it in my own portfolio.
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James Beard owns shares in Rolls-Royce Holdings.
