Despite a recent rally, the Rolls-Royce (LSE:RR) share price is 40% lower than it was at the start of the year. But with the company turning profitable again, is the stock a bargain?
According to Warren Buffett, the amount a company’s stock is worth comes down to the amount of cash it will produce over time. So let’s see how Rolls-Royce stacks up by these metrics.
The Rolls-Royce share price currently values the entire business at around £6.45bn. Last year the company generated £450m in free cash.
That’s a return of just under 7%, which I think is fairly attractive. But the situation isn’t straightforward.
Rolls-Royce also has quite a lot of debt. According to its most recent accounts, the company’s total debt stands at just over £7.7bn.
Too much debt can make a business significantly less attractive from an investment perspective. The more a business has to spend on its debt, the less it can return to its shareholders.
I think that the Rolls-Royce debt is a significant issue for two reasons. The first is the amount of debt the company has and the second is the interest the company has to pay on it.
With £7.7bn in debt, buying Rolls-Royce shares today means taking on debt worth more than the price of the shares. That’s not always a problem, but it needs to be accounted for in an investment decision.
Adding the company’s debt to the price of its shares gives a total cost of around £14bn for the company. And at those prices, a £450m revenue only amounts to a 2.5% return, which is much less attractive.
The other issue is that Rolls-Royce has to pay interest on its debt. At the moment, almost half of the company’s operating income is spent on interest payments.
I think that’s a lot. For context, BAE Systems spends about 20% of its operating income on interest payments, and Halma and Renishaw each spend less than 1%.
Paying too much in interest makes it difficult for Rolls-Royce to bring its overall debt down. That might not be an immediate problem, but I see a significant long-term risk here.
With interest rates rising, I think that the amount that Rolls-Royce pays on its debt is going to increase. And this will make it harder for Rolls-Royce to lower its overall debt.
Is the stock a bargain?
Based on the amount of cash the business generates, Rolls-Royce shares look cheap to me at the moment. But the amount of debt on the company’s balance sheet also makes the stock look risky.
I’m concerned that rising interest rates will get in the way of the company’s ability to generate strong cash returns in the future. As a result, I’m inclined to look for other opportunities.
There’s definitely scope for the business to do well in the future and if the company can clear its debts, then I think that the stock can easily double. But at the moment, the risk outweighs the reward for me.
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Stephen Wright has positions in Halma. The Motley Fool UK has recommended Halma and Renishaw. 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.