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Rolls-Royce shares spike, but here are some red flags I’ve spotted

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Image source: Getty Images

Since the Rolls-Royce (LSE:RR) 2022 results came out last week, the share price can’t stop moving higher. It was trading around 107p before the release, and now sits at 149p.

In fact, Rolls-Royce shares are now at the highest level since November 2021 and are up 19% over the past year. Despite all this good news, there were a few red flags I spotted in the report.

Paying off debt from here

A lot was made of the reduction in net debt, from £5.1bn to £3.3bn over the course of the year. Many (myself included) had flagged up how dangerous the high debt level was. The fact that it has been reduced is good, but there’s something weighing on my mind going forward.

The bulk of the reduction in the debt was due to using the cash proceeds from selling off assets. Going forward, the business doesn’t have more divisions it wants to sell off to generate £3.3bn. So I’m unsure exactly how it plans to reduce this debt pile further until it becomes more manageable.

Free cash flow and retained profits could be used, but that’s dependant on future business performance. The bottom line here is that while we’re praising the reduction in debt, it was actually a one-off event from the large cash proceeds. Reducing it further this year and beyond could be a much harder task.

Not sure about a value buy

Another concern is the value of the stock, given both the jump in the adjusted earnings per share and the share price. A good valuation metric I use is the price-to-earnings ratio. The FTSE 100 average ratio tends to be around 15 in the long run. At a stock specific level, I usually judge anything with a ratio of 10 or below as a potentially undervalued buy.

Given the adjusted earnings per share of 1.95p and a share price of 146p, the Rolls-Royce P/E ratio is 74. Granted, I can look at alternative figures. These include using the non-adjusted earnings figure, or looking at the forecasted figure for next year. But by itself, the figure could indicate that investors have jumped the gun here and pushed the share price up too much too quickly. It could make the stock overvalued in the short term.

Trying not to be pessimistic

After all the battering over the past few years, I really do want to get onboard and buy Rolls-Royce shares. For the most part, the annual report was very positive. The outlook of operating profit potentially hitting £1bn this year, along with growth in the key Civil Aerospace division is music to my ears.

Yet I just feel that the business and the share price don’t quite match up. I think some are buying the stock based on where the company could be in the future, and not where it actually is right now.

There’s nothing wrong with this, but I’d rather see this short-term spike correct lower first before considering buying.

The post Rolls-Royce shares spike, but here are some red flags I’ve spotted appeared first on The Motley Fool UK.

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Jon Smith 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.

Motley Fool UK 2023