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Why the Rolls-Royce share price could continue to outperform

Image source: Rolls-Royce Holdings plc
Image source: Rolls-Royce Holdings plc

Let there be no suspense – I think the Rolls-Royce (LSE:RR) share price looks like a bargain, even after a 197% increase over the last year. And last week’s news seemed to confirm this.

The company announced engine flying hours are back to their 2019 levels and reiterated its targets for this year. The stock didn’t react, but I sense the market’s making a mistake.

The bull case

I believe the bull case for Rolls-Royce shares has been the same for some time. The company’s aiming to achieve £3.1bn in free cash flows by 2027.

Put simply, I think the stock’s a great value if the underlying business can achieve this. The firm has a market-cap of £37bn, which means £3.1bn a year amounts to an 8.3% return.

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That’s about double the return offered by a 10-year UK government bond at the moment. So if things go to plan, the stock will look like a bargain at today’s prices.

Obviously, Rolls-Royce might not hit its targets until 2027 and the stock should reflect this risk. But with things going to plan, I take the view the share price should be higher than it is.

Trading update

Last week, the company announced that engine flying hours had recovered to pre-Covid levels. And management reiterated its forecasts for the current year.

Both of these developments are very positive, in my view. The foundation of the recovery in the Rolls-Royce share price has been a return to pre-pandemic demand for flying.

This has set the company off on a virtuous cycle. Higher free cash flows have led to lower debt, which has reduced interest payments, leading to higher free cash flows – and so on.

All of this has been propelling the stock higher and the latest update indicates that things are going well. The share price however, was largely unmoved by the latest news.

Optimism

I’ve been seeing reports that the number of engine flying hours was expected to come in even higher than it did. That probably explains the market’s subdued response.

As I see it, the company being on track is absolutely fine given its stated targets and the current level of the stock. But it does point towards a genuine risk with the business.

If travel demand does start to weaken, Rolls-Royce might find its growth slows significantly. And that could jeopardise the 2027 target that the bullish thesis is built on.

A rising cost of living makes it impossible to eliminate this risk entirely. But that’s why I think the latest update reiterating that things are on track is a significant positive.

Still a bargain?

At today’s prices, I don’t believe Rolls-Royce needs to to anything spectacular for the stock to be good value. It just needs to stay on track to meet its medium-term targets.

Each time the company reports this is the case, I think the risk with the stock goes down and the share price should go up. Whether it’s the best FTSE 100 stock to buy right now is another question, but I certainly expect it to outperform the index.

The post Why the Rolls-Royce share price could continue to outperform appeared first on The Motley Fool UK.

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Stephen Wright 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.

Motley Fool UK 2024