It’s hard to argue with Rolls Royce (LON:RR.) if you want a company which can produce steady income growth over the long-term with limited risks, but how does it stack up as a value investment at almost 830p a share?
With sales and profits measured in billions, as well as staff measured in tens of thousands across the globe, there are few companies that are safer. In fact the company’s past results are so impressive that I’d be more than happy to join existing shareholders as a part owner of this iconic company… but only at the right price.
Between 2002 and 2012 sales have gone from about 360p to almost 600p; adjusted earnings have gone from 11p to almost 48p and the dividend has moved up from 8p to over 17p today. By every meaningful measure the company has more than doubled its return to shareholders and that is exactly what most investors want to see.
Even better than that, the share price has gone from around 150p in 2002 (or if you timed it right, an incredible 70p in March 2003) to the 830p we see today. Even if you just got in at 150p rather than 70p, you would have seen the share price increase by over 450p. If those returns are not spectacular for a blue-chip stock then I don’t know what is.
Break the returns down into their component parts
Returns flow to shareholders from various sources, so let’s have a look at where they came from for our Rolls Royce investor between 2002 and now.
Dividends – The easiest thing to work out is the dividend. Between 2002 and 2012 (inclusive) the total pay-out has been just over 118p.
Earnings growth – With earnings at 11p then and 48p now, earnings have grown by 336%. Assuming the PE ratio had remained the same (at 13.6) until today then the shareholder would have gained about 504p from the growth of the company.
PE ratio changes – As Mr Market’s mood changes, the valuation given to any one company change change by a surprising amount. You only have to look at a chart of Rolls Royce – a huge global company with a relatively steady business – to see that its market value halved in about a year in the initial stages of the credit crunch. For those investors that hung on, they were rewarded as the stock has tripled since the low point. As of today the PE ratio is about 17.3, which is an increase of some 27% since 2002. This has added another 177p to our shareholder’s return.
Implications for the future
So how might our investor fair over the next 10 years? Of course neither I nor anybody else knows what the future will bring, but let’s have a go at working it out anyway. Remember, we’re starting this journey at 830p a share.
Dividends – Assuming a 10% growth rate, which is approximately what the company managed in the previous decade, the dividend will go from 17.5p today all the way up to 41p in 2020, with the total pay-out being 279p.
Earnings growth – With a 10% growth rate, adjusted earnings would go from 48p to 113p in 2020, which would give a share price of 1,958p if the PE ratio stayed at 17.3. That’s a gain of 1,128p from today’s price.
PE ratio changes – This is the big unknown. It is quite literally impossible to know what a company’s PE will be one day to the next, let alone 10 years down the line. However, we can look at some scenarios:
So what does it all mean?
I hope by this brief review that I’ve highlighted some of the most important thinking behind a long-term investment. In the above example I’ve assumed a 10% growth rate for Rolls Royce over the next decade, which many people would probably say is optimistic.
This leads to a reasonable dividend income of 279p, which would be a 34% return on the original investment.
The return from earnings growth would be 1,128p which is a 136% return in 10 years, which is a reasonably good result, but it will only be seen IF the PE ratio stays above the 17 it’s at today.
The big question, and the big risk, is the current valuation multiple. With the PE at 17 there is a long way down to some of the recent low valuations, where investors have seen the PE as low as 9 and even lower at 6.5 in the last two bear markets.
If the shares fell back to a PE of 6.5 because of a future bear market or a run of bad results for the company, then even if Rolls Royce doubled in size again in the next decade like it has in the past, investors could see almost no return from 10 years of ownership.
On that basis, even though I really like the company, I don't think the shares are good value for money at the moment.
This article is for information and discussion purposes only and nothing in it should be construed as a recommendation to invest or otherwise. The value of an investment may fall and an investor may lose all their money. Any investments referred to in this article may not be suitable for all investors. Investors should always seek advice from a qualified investment adviser.