After drifting below 100p in the middle of July, the Rolls-Royce (LSE: RR) share price has since moved back above 100p. It is currently changing hands around 115p, which is close to its 52-week high of 137p. After this performance, the stock has returned 62% over the past 12 months.
It looks to me as if investor sentiment towards the aerospace group is finally starting to improve. As sentiment improves, the stock price could push higher, although investors may baulk at paying a higher price if the company’s fundamentals do not justify the elevated valuation.
As such, I have been wondering if the Rolls-Royce share price looks cheap at current levels or if it has moved too far too fast.
Rolls-Royce share price valuation
It is always challenging to place a value on loss-making businesses. Unfortunately, Rolls is projected to remain loss-making for the next few years. Moreover, it is difficult to tell if the aviation industry will ever recover to 2019 levels of activity.
Hopefully, the industry will not need to recover fully for Rolls to return to profit. The company slashed operating costs last year in an attempt to rightsize itself in the post-pandemic world. This should help the group pull itself out of the hole it currently finds itself in when the market starts to recover.
Rolls posted an underlying operating profit of £307m in the first half of its financial year thanks to these cost reductions. For the full year, the enterprise is projected to report a loss of £162m.
Management believes the business will start generating free cash flow over the next 12 months. If it does, that will make it easier for me to value the Rolls-Royce share price.
Based on current forecasts, the company will earn £370m in 2022 and as much as £750m in free cash flow. These numbers suggest the stock is trading at a forward price-to-earnings (P/E) multiple of 25 and a free cash flow yield of 7.8%.
I think that free cash flow yield makes the stock look cheap. Other equities are trading at a free cash flow yield of less than 4%. This implies the stock could more than double from current levels.
However, these are just forecasts at this stage. As I noted above, there is no guarantee the company will hit these earnings and cash flow targets. If it does not, investor sentiment could crumble. If management fails to reduce the cash outflow, Rolls could even have to raise new capital.
With this being the case, while I think the Rolls-Royce share price does look cheap based on management’s growth projections, I am well aware there is a lot that could go wrong between now and the end of 2022.
As such, I am not going to buy the stock at current levels. I am happy to wait on the sideline and see what happens to the group’s growth during the next 24 months before taking a position.
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Rupert Hargreaves 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.