The past year has not been good for shareholders in Rolls-Royce (LSE: RR). The dividend remains suspended. Meanwhile, Rolls-Royce shares have fallen 22% in the past 12 months. Currently, they sell for pennies. I have been considering adding more to my portfolio – but could they be a value trap?
The risk of a value trap
Investors can make costly mistakes when they confuse cheapness for value. Sometimes a share might look cheap on some metrics, for example because its price has fallen, or the price-to-earnings (P/E) ratio looks low.
But it is important to remember something that looks cheap can always get cheaper. That is why I look at a share’s value. This is about what a business ought to be worth based on its prospects, not simply whether the share price has fallen.
Hopefully, that can help me avoid value traps. Thus is where a share looks cheap but actually goes on to fall further. For example, the P/E ratio may be low, but a coming profits fall means that the prospective P/E ratio is actually quite high. When the profits fall, the share price therefore moves down further.
A value trap sounds obvious in theory and, with hindsight, it is. But in practice it can be hard to spot one as an investor with imperfect foresight. At any one time, particular companies look like recovery plays to some investors and value traps to others. It is only over time that it becomes clearer what they really are.
Could Rolls-Royce shares be a value trap?
In fact, I think that describes Rolls-Royce shares right now. For example, using the P/E ratio method of valuation, Rolls-Royce trades on a P/E ratio of 57. On its own, I do not think that looks like good value. However, the company is in recovery mode and so its earnings could grow strongly in the next few years.
Then again, what if the earnings do not grow as much as investors hope? After all, last week’s interim results were alarming. Earnings per share for the period actually fell into negative territory. Per share, the company reported a 19.3p loss compared to a 4.8p profit for the same period last year. There are ongoing risks to profitability, such as the impact of inflation in Rolls-Royce’s supply chain.
Looked at that way, I do think Rolls-Royce shares could yet turn out to be a value trap, despite selling for pennies.
My take
So why do I continue to hold the shares? Although I see that they could turn out to be a value trap, I am hopeful they will not. The business benefits from resilient long-term demand in its markets. Barriers to entry are high. Along with a large installed base of plane engines that need to be serviced, I think that business model could help the company become far more profitable again in coming years.
Costs may grow, but the company has been aggressively trying to reduce them in recent years. Revenues grew in the first half and the company is focused on managing its cost base. I think that could turn it into a very profitable operation again a few years from now.
So I see value in Rolls-Royce shares at today’s price and continue to own them.