Is the Rolls-Royce share price really that expensive at 538p?

The Rolls Royce (LSE:RR.) The stock price bull run shows no signs of slowing down. The share is currently (November 1) 144% more changing hands than twelve months ago. This achievement defies critics who claim the group is overrated. But is that so?

There are a number of ways to assess whether a stock offers good value. The most common is the price-earnings ratio (P/E)..

For the year ending December 31, 2024 (FY24), analysts forecast earnings per share (EPS) of 18.7p. This means the stock is trading at a forward earnings multiple of 28.8.

This is more than twice the average FTSE 100. And I don’t think the group’s shares are particularly cheap.

But wait…

However, others are more expensive.

For example, the forward price-to-earnings ratio of the Magnificent Seven in the US is 35.

But is it accurate to compare Rolls-Royce with seven of the world’s largest technology companies? Maybe. To me, the group seems to combine technical excellence with cutting-edge technology.

Technology stocks are likely to maintain higher valuations for longer. Nothing is guaranteed, but investors are generally willing to pay a higher premium for a company that has the potential to deliver above-average sales and earnings growth.

And if the analysts are right, it looks like Rolls-Royce will deliver impressive financial performance over the next three financial years.

They forecast earnings per share of 21.9p (FY25), 25.6p (FY26) and 29.3p (FY27). If these estimates prove accurate, the stock is currently trading at 18.4 times 2027 earnings.

And by the end of that year, the group will have grown its profits by 56.7%.

Based on this, the stock seems reasonably valued.

However, if there is any sign that it won’t meet these targets, the share price will suffer. Then recently it wobbled Cathay Pacific reported a problem with one of its engines.

And a new pandemic cannot be ruled out. The latter almost destroyed the company.

Another option

An alternative way to assess stocks is to use the price-to-earnings growth ratio (PEG). This is calculated by dividing a stock’s current price-to-earnings ratio by its expected earnings per share growth rate.

Applying this to Rolls-Royce yields a PEG ratio of 0.5. This is less than one, suggesting it offers good value. This could explain why it seems to remain a favorite with investors.

However, those looking for generous levels of passive income are likely to be disappointed. The company is expected to pay a dividend of 5p per share this year, implying a current yield of 0.9%..

But investors generally don’t buy growth stocks for their dividends. They expect excess money to be reinvested, develop new products and come up with smart solutions that will increase profits.

Magnificent Seven yields currently range between 0% and 0.7%. And these paltry returns don’t seem to have affected their stock prices too much.

My opinion

Based on the group’s growth prospects, I think it’s fair to say that Rolls-Royce’s share price still offers some value.

It may not be the cheapest stock on the FTSE 100, but if it can deliver the expected revenue growth, free cash flow and earnings, I don’t think it’s too late to invest.

That’s why I recently accepted a position.