Rolls-Royce share price is cheap by 20%, the DCF model shows

Rolls-Royce (RR) stock has surged to record highs, driven by strong performance across its aviation, energy, and defense segments, with a market capitalization reaching approximately $100 billion. Growth is fueled by rising demand in data centers and nuclear energy, including a UK government-funded small modular reactor project. A discounted cash flow (DCF) model suggests the stock is undervalued by 20%, and the company anticipates significant profit and free cash flow growth through 2028, potentially leading to increased dividends and share buybacks, including an already implemented £1 billion buyback program.

Analysis

Rolls-Royce Holdings plc (RYCEY) has demonstrated significant share price appreciation, reaching a record high of 910p and a market capitalization of approximately $100 billion, reflecting strong performance across its core segments. The energy division is capitalizing on heightened demand from data centers and expansion in nuclear energy, notably through a UK government contract for three Small Modular Reactors (SMRs) supported by £2.5 billion in funding, alongside potential involvement in the £11.5 billion Sizewell C nuclear project. Concurrently, the civil aviation segment is benefiting from a robust market for wide-body jets, with anticipated aircraft orders from China for Airbus, a key client for Rolls-Royce's engines; this could enhance Rolls-Royce's market share in China, particularly given current US-China trade dynamics. The defense business is also projected to grow due to increased global defense spending. Financially, Rolls-Royce has exceeded its previous mid-term targets ahead of schedule and has provided strong forward guidance for 2027 and 2028, forecasting operating profits to reach £2.5bn-£2.8bn and £3.6bn-£3.9bn respectively, with corresponding free cash flow expected to be between £2.8bn-£3.1bn and £4.2bn-£4.5bn. This robust financial outlook underpins expectations for enhanced shareholder returns via dividends and share repurchases, in addition to the current £1 billion buyback program. Technical analysis indicates a sustained bullish trend, with the stock surpassing the 811p resistance level and trading above key moving averages, while a Discounted Cash Flow (DCF) model cited by Simply Wall Street suggests the shares are trading at a 20% discount, implying a fair value of 1,090p.

Key Decisions for Investors

• Evaluate the potential for continued upside in Rolls-Royce shares, considering the synergistic growth across its energy, aviation, and defense sectors, which are bolstered by substantial government contracts and favorable secular trends.
• Closely monitor the company's execution against its ambitious 2027 and 2028 financial targets for operating profit and free cash flow, as achievement could catalyze further shareholder value through increased dividends and share buybacks.
• Investors should consider the current valuation in light of the DCF analysis suggesting a 20% undervaluation and a target price of 1,090p, balanced against the stock's recent record highs and positive technical indicators suggesting further near-term momentum towards the 1,000p level.