Rolls-Royce (LSE: RR.) shares are hot right now. This year, they’ve risen from 300p to 540p – a gain of 80% – on the back of investor excitement.
But how much are the shares really worth as we head towards 2025? Let’s take a look.
The right price
There are a number of ways to try and work out a company’s ‘intrinsic’ value (how much it’s really worth). But no method’s foolproof – they all involve making some assumptions.
One method is to assign an earnings multiple to the near-term earnings per share (EPS) forecast. Given the market’s focus on price-to-earnings (P/E) ratios, this method can make sense.
The problem is it’s hard to know exactly what multiple to use. It’s very subjective. Personally, I feel that a P/E ratio of 20 is about right for Rolls-Royce as it’s an industrial company with a high level of capital expenditures. Given that the EPS forecast for 2025 is 21p, that gives us a price of 420p.
That earnings multiple could be too low however. It seems City analysts believe the shares are worth a higher multiple. Currently, the average price target among the analyst community is 550p, according to my data provider.
That would put the P/E ratio at 26 though. And for me, that’s too high – that’s a tech stock valuation!
Crunching the numbers
Another approach to determining intrinsic value is what’s known as a discounted cash flow (DCF) analysis. This involves forecasting a company’s future free cash flows, ‘discounting’ them to a present value today using a certain interest rate, and then adding them all up.
This strategy’s commonly used by professional investors. Again though, there’s a lot of guesswork involved. With this type of analysis, investors need to forecast future free cash flows and growth rates and then determine an appropriate discount rate. So there’s a lot that can go wrong.
But we can have a go. Currently, Rolls-Royce is expecting to generate free cash flow of £2.1bn-£2.2bn this year. Let’s say that it achieves £2.2bn and then grows this by 15% for the next five years before growth slows to 5% a year for the next decade.
And let’s say that 10%’s the right interest rate to discount future cash flows back to present day values. In this scenario, we get an intrinsic value of about 400p. That’s about 25% below the current share price.
My forecasts may be too pessimistic however. If I increase the cash flow growth rates, the intrinsic value estimate rises.
Better shares to buy?
In summary, it’s hard to know what Rolls-Royce shares are really worth. Ultimately, it depends on the valuation approach used and the assumptions made.
Personally, I think the shares are a little overvalued at current levels. That’s why I’m focusing on other opportunities in the market right now.
The post How much are Rolls-Royce shares really worth as we approach 2025? appeared first on The Motley Fool UK.
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Edward Sheldon has no position in any of the shares mentioned. The Motley Fool UK has recommended Rolls-Royce Plc. 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.
