Looking at Rolls-Royce Holdings (LSE: RR.) shares gives me a headache. There’s plenty about them that makes me want to buy. Yet one key thing stops me every time my finger gets near the ‘buy’ button.
Results for 2022 gave the shares a boost, and I’d say we’re well past the bottom now. But Rolls is still down 50% in five years.
So does that mean there are more gains to come? I think so. After all, 2022 looks like it was the turnaround that we were waiting for.
Cash
Rolls returned to positive cash flow in 2022, to the tune of £505m. That’s good stuff, for sure.
Debt is way down too. The bulk of that was due to disposals, mind. But we’re at the stage where debt can be reduced further from cash flow in the coming years. That’s a major milestone. So why won’t I buy?
To buy a top FTSE 100 stock, I want a good outlook for the coming years. And it looks like Rolls-Royce has that now.
Forecasts are good. I know those are risky and the City folk often get it wrong. But at this stage, it’s nice to see them so bullish.
Growth
They predict strong earnings growth in the next few years, to bring the price-to-earnings (P/E) ratio down to 15 by 2025.
That’s about bang in line with the FTSE 100 average P/E. And for a firm with growth prospects, it all looks fine. Or does it? In fact, the valuation is the one big thing that stops me buying.
Even if a business looks good, I still want to see a good margin of safety. But on that front, I’d say the headline P/E is misleading. And it’s all due to debt.
Adjust
For a company at the same stage as Rolls-Royce but with no debt, I’d like that P/E for sure. But I need to see it adjusted for debt, and we can do that.
The P/E is based on a firm’s market cap, which is what it would cost to buy the whole company. But two companies with the same P/E, one with lots of debt and one with none, just can’t be worth the same.
So, what we can do is add net debt to the market cap. And that tells us what it would take to buy the company and also pay down the debt.
It’s called an Enterprise Value P/E. And it helps level the field when we look at companies with different debt levels.
Too high
So if we allow for the £3.3bn net debt at the end of 2022, that puts the Rolls P/E for 2025 as high as 19. Now, that might still be good value, if we really are back to yearly earnings growth.
But, it’s still three years out, and a lot can go wrong in three years. I just don’t see enough safety in that valuation.
So, Rolls is a stock I’d love to buy for a good few reasons. But I won’t, for that one key reason.
The post Here’s why I won’t buy Rolls-Royce shares right now appeared first on The Motley Fool UK.
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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.