I think it is fair to say that despite the recent success, many investors still believe Rolls Royce (LSE:RR.) The share price offers some value. However, I think some of the analysis I’ve read (not written by my fellow Fools, I hasten to add) is flawed.

I’ve seen one justification for buying Rolls-Royce stock that went something like this: Although the stock is expensive right now, in a few years – assuming earnings grow as forecast – today’s share price will look like a good entry price. Therefore, the argument goes, now is a good time to invest.

To support his point, the author cited future earnings forecasts prepared by brokers.

A long-term perspective

These show that analysts expect earnings per share (EPS) of 15.8p for the financial year ending December 31 (FY24). Based on a current share price (July 5) of 462p, this means the stock is trading at a price-to-earnings (P/E) ratio of 29.2.

This is well above the FTSE 100 average of around 10.5. Many investors therefore consider the stock to be overvalued.

However, earnings per share are expected to be 26.5p for the 2027 financial year. If this pans out, the P/E ratio drops to a more reasonable 17.4. While this is still above the Footsie average, it is not unreasonable for an engineering company.

In other words, the stock may seem expensive today, but that will no longer be the case in 2027.

Am I missing something?

In my opinion, however, this argument makes no sense.

If a P/E ratio of 17.4 represents a fair valuation for Rolls-Royce, the share price in 2027 will be the same as it is today. That’s because 17.4 multiplied by earnings per share in fiscal 2027 (26.5p) gives a share price of 462p. This is the same as today’s value – P/E ratio (29.2) x earnings per share in fiscal 2024 (15.8p) = 462p.

That doesn’t sound like a very good investment to me.

And what happens if we turn the argument around? Let’s say a multiple of 17.4 is fair. Based on the 2024 earnings forecast, the company’s shares should currently be changing hands for 275 pence. — 17.4 x 15.8 pence. That’s about 40% lower than their current level – and supports the theory that they are overvalued.

Final thoughts

My analysis holds as long as investors are rational and consider a multiple of 17.4 to be reasonable. However, if the elevated P/E ratio of 29.2 is maintained through 2027, the company’s shares will be worth 774 pence – a 67% premium to today’s value.

However, I believe that investors are acting rationally and that the majority will soon be of the opinion that the stock should be worth 17 rather than 29. Therefore, I suspect that the rise in Rolls-Royce’s share price will soon lose momentum.

The story continues

Don’t get me wrong, I’m a fan of the company. I think it has a great reputation and has recovered well from the pandemic. I also think that developing small modular reactors – factory-built nuclear power plants – could be very lucrative.

However, I believe there are currently better investment opportunities elsewhere, including stocks that pay a generous dividend, so I will not invest.

However, I will sit back and watch with interest to see where Rolls-Royce’s share price goes next.

The post “Is Rolls-Royce’s share price at 462p still good value for money?” appeared first on The Motley Fool UK.

Further reading

James Beard does not own any of the stocks mentioned. The Motley Fool UK has recommended Rolls-Royce Plc. The views expressed on companies mentioned in this article are those of the author and 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.

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