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Although a recent rally Rolls Royce (LSE:RR) share price is 40% lower than it was at the start of the year. But if the company is profitable again, is the stock a bargain?
According to Warren Buffett, the value of a company’s stock depends on the amount of money it produces over time. So let’s see how Rolls-Royce stacks up on these metrics.
Generate cash
Rolls-Royce’s share price currently values its total business at around £6.45bn. Last year the company generated £450 million in free cash flow.
That’s a return of less than 7%, which I think is very attractive. But the situation is not easy.
Rolls Royce owes a lot. Its latest accounts show the company’s total debt is more than £7.7bn.
Too much debt makes a business much less attractive from an investment perspective. The more a business has to spend on debt, the less it can return to its shareholders.
I think the Rolls Royce debt is an important 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.
Debt
With £7.7bn in debt, buying Rolls-Royce shares today means taking on more debt than the shares are worth. That’s not always a problem, but it should be considered in an investment decision.
Adding the company’s debt to its share price gives the company a total cost of £14 billion. And at those prices £450m of revenue is only a 2.5% return, which is far less attractive.
Another issue is that Rolls Royce has to pay interest on the debt. Currently, about half of the company’s revenue is spent on interest payments.
I think this is too much. For context, BAE Systems It spends 20% of its operating income on interest payments. Halma And Renishaw Each costs less than 1%.
Paying more in interest makes it harder for Rolls-Royce to lower its total debt. That may not be an immediate problem, but I see a significant long-term concern here.
As interest rates rise, I think Rolls Royce will have to pay more for its debt. And this makes it difficult for Rolls-Royce to reduce its total debt.
Is the stock a bargain?
Based on the amount of cash the business generates, Rolls-Royce shares look cheap to me right now. But the amount of debt on the company’s balance sheet makes the stock risky.
I am concerned that rising interest rates will hamper the company’s ability to generate strong financial returns. As a result, I am interested in looking for other opportunities.
There is definitely scope for the business to do well in the future and I think the stock can easily double if the company can clear its debts. But now the risk outweighs the reward.