Rolls-Royce: Why Lower Valuation Multiples Still Justify a Buy Rating

The debate over Rolls-Royce Holdings PLC's (LSE: RR) valuation has intensified in 2025, with conflicting signals from discounted cash flow (DCF) models and earnings multiples. While some DCF analyses suggest the stock is overvalued by 17% to 71%, its forward price-to-earnings (P/E) ratio of 16.1x remains significantly below the 24x average for the aerospace and defense sector according to data. This divergence highlights a critical opportunity for investors: Rolls-Royce's undervalued earnings multiples, combined with its strategic initiatives in defense, clean energy, and power systems, create a compelling case for a long-term buy rating.

DCF Overvaluation: A Matter of Assumptions

DCF models inherently rely on assumptions about future cash flows, growth rates, and discount rates. For Rolls-Royce, these assumptions vary widely. A 2-Stage Free Cash Flow to Equity model estimates an intrinsic value of £9.91 per share, while Alpha Spread's analysis pegs it at 378.06 GBX, implying a 71% overvaluation. Conversely, ValueInvesting.io's £554.77 fair price suggests a 48.6% downside from the current £1,079.00 share price. These discrepancies stem from differing views on the company's ability to sustain its recent performance.

Critics argue that Rolls-Royce's civil aviation and defense sectors, while strong, may face headwinds from macroeconomic volatility or regulatory shifts. However, the company's 11% annualized operating profit growth forecast from 2024 to 2028-backed by a £1.1 billion net cash position at the half-year 2025-provides a buffer against such risks. This financial resilience, coupled with a forward P/E ratio that discounts future growth, suggests the market may be underestimating Rolls-Royce's long-term potential.

Strategic Catalysts: Defense, Clean Energy, and SMRs

Rolls-Royce's strategic initiatives in 2025 offer a roadmap for unlocking value. In defense, the company has secured a five-year partnership with AVK, a UK-based power solutions provider, to supply mtu Series 4000 emergency generators for data centers. This collaboration not only ensures production capacity but also aligns with the growing demand for sustainable technologies like HVO-compatible generators. AVK's role as the exclusive system integrator in the UK and Ireland further solidifies Rolls-Royce's market position in this high-growth segment.

The company's Small Modular Reactor (SMR) program represents an even more transformative opportunity. The UK government has selected Rolls-Royce as the preferred bidder for its first SMR program, with £2.5 billion in public funding to develop three 480-MW reactors. By 2030, the SMR division is projected to become profitable and free cash flow positive, driven by a global market expected to grow at a 23.9% CAGR from 2025 to 2030. Rolls-Royce's partnerships with ČEZ Group and BWXT to advance nuclear steam generator design and its alignment with the Atlantic Partnership for Advanced Nuclear Energy underscore its leadership in this emerging sector.

Market Dynamics and Financial Projections

The SMR market's expansion is not merely speculative. Mordor Intelligence forecasts installed capacity to rise from 312.5 MW in 2025 to 912.5 MW by 2030, while another report projects the market size to grow from $7.49 billion in 2025 to $16.13 billion by 2034. Rolls-Royce's factory-built, scalable SMRs are uniquely positioned to capitalize on this growth, particularly in off-grid industrial applications and decarbonization-driven markets.Financially, the company's half-year 2025 results reinforce its credibility. With a net cash position of £1.1 billion and a 11% annualized operating profit growth forecast, Rolls-Royce has the liquidity and operational discipline to navigate capital-intensive projects like the SMR program. The Regulated Asset Base (RAB) model, which the UK government plans to adopt for SMR financing, further reduces investor risk by providing predictable returns.

Conclusion: A Buy Rating Justified

While DCF models may paint a mixed picture, Rolls-Royce's undervalued P/E ratio and strategic upside create a compelling case for investors. The company's lower valuation multiples reflect market skepticism about its ability to sustain growth, but its defense contracts, AVK partnership, and SMR program offer tangible catalysts for earnings expansion. As the global shift toward clean energy accelerates and defense spending remains robust, Rolls-Royce is well-positioned to outperform its valuation metrics. For long-term investors, the current discount to intrinsic value-coupled with a strong balance sheet and high-conviction growth initiatives-makes a buy rating not just prudent, but necessary.