2 reasons why Rolls-Royce shares could take off!
Since August 2022, the value of Rolls-Royce Holdings (LSE:RR.) shares has soared by more than 1,200%. With all the hype surrounding the Magnificent 7 and the impact of artificial intelligence, itâs easy to overlook this remarkable performance. After all, Nvidiaâs stock price has increased by âonlyâ 980% over the same period.
Looking to the future
We are told that share prices reflect the discounted future cash flows of a business. The consensus of analysts is for Rolls-Royce to have free cash flow of £4.49bn in 2028. With a current (20 August) stock market valuation of £89.3bn, it means the groupâs shares trade on 19.9 times this figure.
Forecasts rarely look further ahead than three or four years. There are too many moving parts for predictions to be meaningful beyond this period. Itâs therefore probably not a coincidence that this is also the average length of time that investors hold a particular stock. A 2023 survey by The Investment Association found that 3.6 years is typical. Calastone says the average holding period is now four years, down from seven years in 2016.
Why is this relevant to the Rolls-Royce share price?
Well, if investors are planning to hold a stock for only four years, it stands to reason that they arenât looking at the aerospace and defence groupâs prospects beyond 2029. And yet the 2030s could be transformational for the group. This is when two new earnings streams might emerge.
Going nuclear
The first involves small modular reactors (SMRs). These are factory-built mini nuclear power stations. Iâve seen one forecast suggesting that 700 will be needed by 2050. If Rolls-Royce sold (say) five each year for £2.2bn each at a 15% margin, it would add £1.65bn to its bottom line. Assuming this translated into cash, at a multiple of 19.9, it could add over £32bn to the groupâs value.
But the technology is still unproven. Although two SMRs exist â in China and Russia â they are not operating commercially. There are dozens of different designs using alternative cooling methods that are currently being assessed. Nobody knows which (if any) are likely to succeed.
Flying higher
The second new opportunity is the supply of engines to the narrowbody aircraft market. By 2032, this could be worth $150bn a year. If the group captured 15% of this (itâs believed to have one-third of the widebody market) at a 20% margin, it could generate $4.5bn (£3.3bn) of profit a year. If this converted into free cash, it could add another £62bn to the groupâs market cap.
But itâs never easy entering a new market, especially one where long-standing relationships exist between aircraft manufacturers and suppliers. And the pandemic highlighted how vulnerable the sector can be to disruption.
Also, the situation is a little more complicated than this. The majority of engine revenue is earned over a period of many years and a similar model might be adopted for SMRs. However, both have the potential to take the groupâs financial performance to another level. If these two revenue streams could add close to £100bn to the groupâs stock market valuation over the next decade, I donât see why its share price couldnât double.
For this reason, Rolls-Royce stock could be one for long-term investors — those looking more than four years ahead — to consider.
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More reading
- 3 reasons I donât own Rolls-Royce shares
- Why is everyone talking about Rolls-Royce shares?
- Could AI lift the Rolls-Royce share price by 93% and make the group the UK’s number 1?
- The hidden risks behind the Rolls-Royce share price rally (and why they may not matter)
- Rolls-Royce could become the largest company on the London Stock Exchange, according to CEO Tufan Erginbilgiç
James Beard has positions in Rolls-Royce Plc. The Motley Fool UK has recommended Nvidia and 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.
