Executive Summary & Investment Thesis

Rolls-Royce Holdings PLC stands at a pivotal juncture, having navigated a period of intense operational and financial distress to emerge as a revitalized and strategically focused enterprise. The company’s transformation, initiated in early 2023, has yielded results that have materially outpaced initial expectations, driving a fundamental reassessment of its earnings power and long-term potential. This analysis posits an investment thesis centered on three core pillars: the successful execution of a credible corporate turnaround, the enduring strength of its high-barrier core franchises, and the significant, underappreciated value of its long-duration growth options in the global energy transition.

The first pillar of the thesis is the credible and executed turnaround. The dramatic financial improvements between 2022 and 2024 are not merely a function of a cyclical market recovery but are the direct result of a rigorous, management-led transformation. This program has focused on commercial optimization, particularly in its long-term service agreements; stringent cost discipline through simplification and efficiency programs; and a more disciplined approach to capital allocation.¹ The tangible outcomes—a near quadrupling of operating profit, a swing from £3.3 billion in net debt to a net cash position, and the reinstatement of the dividend—provide clear evidence of a structural, not temporary, improvement in the company’s operational and financial health.⁵

The second pillar is the durability of Rolls-Royce’s high-barrier franchises. The company’s core businesses possess significant and sustainable competitive moats. In Civil Aerospace, its dominant position in the wide-body engine market is protected by decades of technological investment, a massive installed base, and the highly profitable, long-term “TotalCare” service contracts that create a sticky, recurring revenue stream.¹ In Defence, its role as a sole-source provider of nuclear propulsion for the UK’s submarine fleet and its position on key long-term international programs provide decades of revenue visibility, insulated from commercial cycles.¹ In Power Systems, its focus on mission-critical power for resilient end-markets like data centers offers stable, non-correlated growth.⁸ These are not commodity businesses; they are deeply integrated technology and service platforms with high switching costs.

The third and most transformative pillar is the portfolio of embedded long-term growth options, which offer the potential to redefine the company’s strategic profile over the next decade. Foremost among these is the Small Modular Reactor (SMR) business. Far from a speculative venture, Rolls-Royce SMR has achieved significant commercial and regulatory milestones, including being selected as a preferred technology partner in the UK, the Czech Republic, and Sweden.⁹ This positions the company as a key enabler of the global energy transition, addressing the massive demand for clean, baseload power. This venture represents a material, long-duration growth catalyst that could fundamentally alter the company’s valuation profile over time.

While the path forward is not without risks—including engine durability challenges, persistent supply chain constraints, and the inherent cyclicality of commercial aviation—the strategic actions taken have made Rolls-Royce a more resilient and financially robust enterprise. The company’s ability to successfully manage these headwinds while executing on its growth initiatives will be critical.

Key Monitoring Metrics

For ongoing analysis, the following key performance indicators (KPIs) are critical to track:

• Operational Metrics:

• Large Engine Flying Hours (EFH): The primary driver of high-margin aftermarket services revenue in Civil Aerospace.²
• Engine Shop Visits & Deliveries: Indicators of MRO activity and market share in new wide-body aircraft.¹
• Order Backlog: Provides visibility into future revenues across all segments.
• Financial Metrics:

• Free Cash Flow (FCF) Generation: The ultimate measure of the transformation’s success and the company’s ability to invest and return capital to shareholders.³
• Net Debt / EBITDA: A key measure of balance sheet health and financial resilience.
• Return on Invested Capital (ROIC): A measure of the efficiency and profitability of capital allocation.⁶
• Segment-Level Operating Margins: Crucial for assessing the profitability improvement in each core division and benchmarking against peers.
• Strategic Milestones:

• SMR Program Progress: Key milestones such as the completion of the UK’s Generic Design Assessment (GDA), firm orders, and new international partnerships.¹¹
• Engine Time-on-Wing (ToW) Improvement: Progress against the stated goal of improving the durability and reducing the maintenance burden of the Trent engine family.¹

Financial Health Assessment: A Turnaround Forged in Crisis

The financial recovery of Rolls-Royce between 2022 and 2024 has been profound, marking one of the most significant turnarounds in the European industrial sector. The improvement transcends a simple cyclical rebound in its end markets and points to a structural enhancement of the company’s profitability, cash generation, and balance sheet strength. This was achieved through a multi-faceted transformation program that prioritized commercial discipline, cost efficiency, and rigorous performance management.

Profitability and Margin Expansion

The most visible evidence of the turnaround is in the company’s profitability metrics. On an underlying basis, which management uses to reflect the substance of trading activity, operating profit surged from £652 million in 2022 to £1.6 billion in 2023, and then again to £2.5 billion in 2024.² This represents a near-quadrupling of profit in just two years.

This profit growth was driven by a dramatic expansion in operating margins. The group’s underlying operating margin expanded from 5.1% in 2022 to 10.3% in 2023, reaching a robust 13.8% in 2024.⁵ This improvement was broad-based, with all three core divisions delivering materially higher margins. The Civil Aerospace division saw the most significant leap, with its margin expanding from just 2.5% in 2022 to 11.6% in 2023, driven by higher aftermarket volumes and, critically, improved pricing and commercial terms on its long-term service agreements.¹ The Defence division improved its margin to 13.8% in 2023 from 11.8% in 2022, reflecting better pricing and cost control, while Power Systems saw its margin climb to 10.4% from 8.4% over the same period.¹

This performance is directly attributable to the transformation plan’s focus on “commercial optimisation” and “cost efficiencies”.¹ The speed of this turnaround has notably outpaced the company’s own initial projections. At its Capital Markets Day in November 2023, Rolls-Royce laid out a multi-year plan with mid-term financial targets. However, the performance delivered in the 2024 full-year results indicates that the company is on track to achieve its profit and cash flow targets two years earlier than originally guided.¹² This acceleration suggests that the internal levers of cost reduction, procurement savings, and commercial renegotiation are proving more potent and are being executed with greater pace than anticipated, lending significant credibility to the management team’s ability to deliver on its strategic goals.

A key underlying driver of this sustainable improvement is the structural change in the company’s cost base. A critical metric, the Total Cash Cost to Gross Margin (TCC/GM) ratio, which measures the proportion of gross profit consumed by operating cash costs like R&D and administrative expenses, has seen a remarkable improvement. This ratio fell from 0.80x in 2022 to 0.59x in 2023, and further to a best-in-class 0.47x in 2024.⁵ This is not merely a function of higher revenue; it is a direct result of structural cost-out programs, including zero-based budgeting and over £500 million in cumulative procurement savings.⁴ This fundamental enhancement of the company’s operating leverage means that as revenues grow, a significantly larger portion of that revenue will convert into operating cash flow, creating a more profitable and resilient business model.

Cash Flow Generation and Balance Sheet Fortification

The ultimate validation of the turnaround lies in the company’s ability to generate cash. Free cash flow from continuing operations grew from £505 million in 2022 to a record £1.3 billion in 2023, before accelerating again to £2.4 billion in 2024.² This powerful cash generation was driven primarily by the growth in operating profit, alongside continued growth in the balance of long-term service agreements (LTSA) as engine flying hours recovered.²

This robust cash flow has enabled a dramatic deleveraging and strengthening of the balance sheet. The company transitioned from a net debt position of £3.3 billion at the end of 2022 to £2.0 billion at the end of 2023, before reaching a net cash position of £475 million by the close of 2024.⁵ This rapid fortification of the balance sheet was a key strategic priority and its achievement was recognized by all three major credit rating agencies, which restored the company’s investment-grade status in 2024.⁶ Achieving an investment-grade rating is a crucial milestone, as it lowers the company’s cost of capital, improves financial flexibility, and signals a return to fundamental stability. With a strong liquidity position of £8.1 billion at the end of 2024, the company now has a solid foundation from which to pursue its strategic investments and shareholder return policies.⁶

Capital Allocation and Shareholder Returns

With the balance sheet repaired, management has shifted its focus to a disciplined capital allocation framework. This framework prioritizes investment in profitable growth opportunities, maintaining an investment-grade balance sheet, and delivering shareholder returns.¹³ The philosophy has moved decisively away from a historical focus on winning market share towards a focus on the quality of earnings, cash conversion, and return on capital.¹³

A significant signal of management’s confidence in the sustainability of the turnaround was the reinstatement of the dividend, announced with the full-year 2024 results. The company proposed a final dividend of 6.0p per share, marking the first shareholder payment since they were suspended in 2020 during the pandemic.³ The reintroduction of a dividend, based on a 30% payout ratio of underlying profit after tax, underscores the belief that the improved cash flow generation is durable and provides a clear policy for future capital returns.³

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Table 1: Rolls-Royce Holdings PLC – Key Financial Metrics (2022-2024)

Metric	2022	2023	2024
Underlying Revenue (£m)	12,691	15,409	17,848
Underlying Operating Profit (£m)	652	1,590	2,464
Operating Margin (%)	5.1%	10.3%	13.8%
Underlying EPS (pence)	1.95	13.75	20.29
Free Cash Flow (£m)	505	1,285	2,425
Net Debt/(Cash) (£m)	(3,251)	(1,952)	475
Return on Capital (%)	4.9%	11.3%	13.8%

Source: Rolls-Royce Holdings PLC Annual Reports and Full Year Results Announcements.² Note: 2024 EPS and Return on Capital are adjusted for a one-off deferred tax credit.

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Core Business Deep Dive & Competitive Positioning

Rolls-Royce operates through three core divisions—Civil Aerospace, Defence, and Power Systems—each possessing distinct market characteristics, competitive dynamics, and strategic importance. The recent transformation has driven significant performance improvements across all segments, reinforcing their respective market positions.

Civil Aerospace: The Wide-Body Powerhouse

The Civil Aerospace division is the company’s largest and most strategically critical segment, representing the primary engine of both revenue and, following the turnaround, profit. Its competitive moat is built on a formidable position in the global market for wide-body aircraft engines. Rolls-Royce powers four out of five new-generation large aircraft types and maintains a 33% share of the global in-service large engine fleet.¹ Critically, its share of the future market is even stronger, with 41% of all wide-body engines currently on order.¹

This market position has been strengthened recently. In 2023, a year that marked the best for wide-body engine orders since 2007, Rolls-Royce secured major contracts from flagship carriers including Air India, Turkish Airlines, and Emirates.¹ As a result, over half of all new wide-body aircraft delivered in 2023 were powered by Rolls-Royce engines, further growing its installed base of over 4,860 engines.¹

The division’s business model is centered on the monetization of this installed base through long-term service agreements, branded as “TotalCare.” These contracts, which can span 15 years or more, generate highly profitable, recurring revenue streams tied to engine flying hours (EFH).¹ As global long-haul travel recovered post-pandemic, EFH reached 88% of 2019 levels in 2023, driving a 25% increase in services revenue to £4.6 billion.¹ This, combined with aggressive commercial optimization of these contracts, propelled the division’s operating margin from a mere 2.5% in 2022 to a robust 11.6% in 2023.¹

However, the strategic focus on the wide-body market is not without risk. While it offers higher barriers to entry and more lucrative aftermarket revenue per engine compared to the narrow-body market, it also exposes the company more acutely to downturns in long-haul international travel, as was starkly demonstrated during the COVID-19 pandemic. The ongoing development of highly efficient, long-range narrow-body aircraft, such as the Airbus A321XLR, presents a long-term strategic consideration. These aircraft are increasingly capable of serving “long, thin” routes that were previously the exclusive domain of smaller wide-body jets.¹⁵ While this trend is unlikely to threaten core, high-density intercontinental routes, it could gradually erode the addressable market for some wide-body platforms over the next decade. This dynamic elevates the importance of Rolls-Royce’s execution on its current Trent engine programs and the successful development of its next-generation UltraFan technology to maintain its competitive edge.

Defence: Capitalizing on Geopolitical Instability

The Defence division serves as a crucial source of stability and long-term, predictable cash flow, acting as a powerful counterbalance to the cyclicality of the civil aerospace market. The division is a market leader in engines for military transport and patrol aircraft and holds a unique, sole-source position as the designer and manufacturer of the nuclear reactors that power the entire UK Royal Navy submarine fleet.¹

The strategic importance of this division has grown significantly in the current geopolitical climate. Global military expenditure saw its steepest year-on-year increase in 2024 since the end of the Cold War, with spending rising by 9.4% in real terms to $2.7 trillion.¹⁷ This trend provides a strong tailwind for the Defence division, which is underpinned by a robust £9.2 billion order book.¹

Furthermore, the division has secured several franchise-defining, multi-decade contracts that provide exceptional long-term revenue visibility. These include the contract to re-engine the entire US Air Force B-52 bomber fleet with its F130 engine and its role in providing reactors for Australia’s new nuclear-powered submarines under the trilateral AUKUS security pact.¹ These programs de-risk the overall investment case for Rolls-Royce, providing a stable foundation of high-quality earnings that can support R&D investment in other parts of the business. The division’s financial performance is strong and improving, delivering an operating margin of 13.8% in 2023.¹

Power Systems: A Resilient Industrial Engine

The Power Systems division, which operates under the mtu brand, provides mission-critical, integrated power and propulsion solutions to a diverse range of industrial end-markets.⁸ Its key markets include power generation, governmental and defense applications, and marine propulsion.¹⁹

The division has demonstrated resilient growth and strong profitability. In 2023, its underlying revenue grew by 16%, a performance driven by a remarkable 34% surge in its power generation business.¹ This growth is directly linked to the global expansion of data centers, which require reliable backup power solutions—a core offering of the Power Systems division.¹ This secular trend provides a strong, non-cyclical growth driver. The division’s profitability has also improved significantly as a result of the group’s transformation program, with better pricing and cost efficiencies driving the operating margin up to 10.4% in 2023 from 8.4% in 2022.¹

Competitive Benchmarking

A comparison with its primary aerospace peers—GE Aerospace, Safran, and RTX’s Pratt & Whitney—provides essential context for Rolls-Royce’s performance and strategic positioning.

GE Aerospace sets the industry benchmark for profitability. In 2024, its Commercial Engines & Services (CES) segment, which competes directly with Rolls-Royce’s Civil Aerospace division, reported an exceptionally high operating profit margin of 26.2% on revenues of $26.9 billion.²¹ This figure highlights the significant potential for further margin expansion at Rolls-Royce as its transformation matures and aftermarket efficiencies are fully realized.

Safran, GE’s 50:50 joint venture partner in the narrow-body focused CFM International, also demonstrates strong performance. Its Propulsion segment achieved a 20.6% operating margin in 2024.²² The success of the CFM56 and new LEAP engines in the high-volume narrow-body market contrasts with Rolls-Royce’s strategic concentration on the wide-body segment.

Pratt & Whitney (a subsidiary of RTX) provides a cautionary tale on the impact of technical risk. Its financial results show a recovery to a 7.2% operating margin in 2024 after incurring a significant operating loss in 2023.²³ This loss was driven by a multi-billion dollar charge related to widespread reliability issues with powder metal components in its GTF engines, which grounded hundreds of aircraft.²³ This event underscores the severe financial and operational consequences that can arise from engine reliability problems, a risk inherent to all original equipment manufacturers (OEMs) in the industry.

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Table 2: Aerospace & Defence Peer Comparison (FY2024)

Company (Segment)	Segment Revenue	Segment Operating Profit	Segment Operating Margin (%)	Group EV/EBITDA (TTM)
Rolls-Royce (Group)	£17.8bn	£2.5bn	13.8%	13.1x
GE Aerospace (CES)	$26.9bn	$7.1bn	26.2%	16.5x (Group)
Safran (Propulsion)	€13.7bn	€2.8bn	20.6%	12.8x (Group)
RTX (Pratt & Whitney)	$28.1bn	$2.0bn	7.2%	14.9x (Group)

Source: Company Annual Reports and Financial Releases.³ Note: Rolls-Royce figures are for the full group on an underlying basis. Peer segment data is for their respective commercial/propulsion divisions. EV/EBITDA multiples are approximate based on publicly available data as of mid-2025 and are for the entire corporate entity.

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Growth Catalysts & Future Technologies

Beyond the immediate financial turnaround, Rolls-Royce’s long-term value proposition is increasingly defined by its strategic investments in next-generation propulsion, clean energy solutions, and sustainable aviation technologies. These initiatives are not peripheral; they represent core pillars of the company’s future growth strategy, with the potential to significantly expand its addressable markets and enhance its competitive standing.

Next-Generation Propulsion: UltraFan and Pearl

Technological leadership remains the cornerstone of the Civil Aerospace franchise. The company’s primary long-term development program is the UltraFan demonstrator engine. This program represents a step-change in gas turbine architecture, incorporating a geared design, advanced composite materials for the fan blades, and a new engine core. The technology promises a 25% improvement in fuel efficiency compared to the first generation of Trent engines, which translates directly into lower emissions and operating costs for airlines.²⁴ The UltraFan architecture is scalable, making it a potential candidate for both future wide-body and narrow-body aircraft, and it has been designed to be 100% compatible with Sustainable Aviation Fuels (SAF) from its first day in service.²⁴

In the highly profitable business aviation segment, Rolls-Royce is cementing its market leadership with the new Pearl engine family. The Pearl 700 engine powers Gulfstream’s new flagship G700 and long-range G800 jets, while the more powerful Pearl 10X has been selected for Dassault’s upcoming Falcon 10X.²⁵ These programs are critical, as the company has explicitly stated that its commercial optimization efforts have successfully made new business aviation engine deliveries profitable, a significant shift from the historical model of relying solely on aftermarket services for profitability.³

The Energy Transition Opportunity: Small Modular Reactors (SMRs)

Arguably the most significant and potentially transformative long-term growth catalyst for Rolls-Royce lies outside of its traditional aerospace and defense markets. The Rolls-Royce SMR business is developing a 470 MWe “factory-built” nuclear power plant based on proven and reliable pressurized water reactor (PWR) technology.²⁷ The core innovation is not in the nuclear science but in the manufacturing and deployment model, which focuses on modular construction in a factory setting to reduce cost, construction time, and project risk compared to large-scale nuclear plants.²⁷

This initiative has gained substantial commercial and political momentum, moving it from a conceptual project to a credible business venture. Key milestones include:

• Regulatory Progress: The Rolls-Royce SMR design has successfully completed Step Two of the UK’s rigorous Generic Design Assessment (GDA) process and is now in the final stage, making it the most advanced SMR design in any European regulatory process.¹¹
• Commercial Selections: The technology has been chosen by Great British Energy-Nuclear for the UK’s first fleet of SMRs.¹¹ Internationally, it has been selected as a preferred technology partner by major European utilities, including ČEZ in the Czech Republic for a potential 3 GW deployment and Vattenfall in Sweden.⁹

These developments provide tangible evidence of a clear path to market. The SMR business addresses the enormous global demand for clean, reliable, baseload electricity, a market being driven by the electrification of economies and the exponential growth of energy-intensive data centers.²⁷ This venture has the potential to transform Rolls-Royce from a pure-play A&D industrial into a key player in the global energy transition. As the SMR unit progresses from a development cost center towards generating positive cash flow (targeted for late 2025) and profitability (by 2030), the market will likely be compelled to assign a discrete and substantial valuation to this business, which could act as a significant catalyst for the parent company.²⁸

Sustainable Aviation Fuels (SAF) and Hydrogen

Rolls-Royce is positioning itself as a critical enabler of aviation’s decarbonization pathway. The company has successfully completed testing to prove that all of its in-production civil aero engines, including the entire Trent family and the Pearl business jet engines, are compatible with 100% SAF.²⁹ This is a crucial step, as SAF is considered the most viable near-to-medium-term solution for reducing the carbon footprint of long-haul aviation.

Looking further ahead, the company is actively investing in disruptive technologies. In partnership with airline easyJet, Rolls-Royce conducted the world’s first successful ground test of a modern aero engine running on green hydrogen.²⁴ While hydrogen propulsion faces significant infrastructure and aircraft design challenges, this research positions Rolls-Royce at the forefront of a potential long-term technological shift.

A powerful, and perhaps unique, synergy exists between the company’s SMR and SAF strategies. One of the primary barriers to the widespread adoption of SAF, particularly synthetic e-fuels, is the immense amount of clean, low-cost energy required for its production.³¹ Rolls-Royce explicitly markets its SMRs as a solution for manufacturing synthetic fuels.²⁷ This creates the potential for a closed-loop value chain where Rolls-Royce not only manufactures the engines that consume SAF but also provides the core technology (SMRs) to produce the clean energy needed to create that fuel. This unique positioning could offer a compelling proposition to governments and energy partners focused on building a sustainable aviation ecosystem.

Risk Factor Prioritization & Headwinds

Despite the significant progress of its transformation and its compelling growth prospects, Rolls-Royce faces a range of material risks that require careful monitoring. These risks span the technical, operational, macroeconomic, and geopolitical domains and could impact the company’s ability to achieve its financial targets.

Technical and Operational Risks: Engine Durability and Supply Chain

The most significant and immediate operational risk for Rolls-Royce is centered on engine reliability and durability. The company has a history of costly technical challenges, most notably the issues with turbine blade cracking on its Trent 1000 and 900 engines, which led to over £1 billion in charges, significant operational disruption for airline customers, and reputational damage.³² While those specific issues have been largely addressed through redesign and retrofit programs, concerns about engine durability persist. More recently, prominent customers such as Emirates have publicly criticized the time-on-wing performance of the Trent XWB-97 engine, which powers the Airbus A350-1000, particularly in harsh, sandy, and hot operating environments.³³

Rolls-Royce is actively investing to mitigate this risk, with a £1 billion multi-year program aimed at improving the durability of its modern Trent engines. Key initiatives include developing more resilient coatings for high-pressure turbine blades and designing components that extend the time an engine can remain in service between major overhauls.¹ The success of this program is critical for managing aftermarket costs and maintaining customer confidence.

Compounding this technical challenge is the fragile state of the global aerospace supply chain. The entire industry is grappling with persistent constraints, including shortages of raw materials, forged and cast components, and skilled labor.³⁴ For Rolls-Royce, these bottlenecks impact both the production of new engines and, critically, the capacity of the maintenance, repair, and overhaul (MRO) network to service the existing fleet. Management has indicated that they expect these supply chain challenges to remain a significant factor for another 18 to 24 months.³³

These two risks—engine durability and supply chain constraints—create a negative feedback loop. When an engine requires more frequent maintenance due to a durability issue, it places additional demand on an MRO network that is already capacity-constrained by labor and parts shortages. This can lead to longer turnaround times for engine repairs, forcing airlines to ground aircraft and causing further customer frustration. Furthermore, supply chain bottlenecks can slow down the production and distribution of the newly designed, more durable parts needed to fix the underlying reliability issues across the in-service fleet. This dynamic means that the financial and operational drag from durability problems may have a longer tail than anticipated, even after the engineering solutions have been developed.

Execution and Macroeconomic Risks

The company’s financial performance remains heavily exposed to the cyclical health of the global economy and the commercial aviation market.³⁶ A significant global economic downturn would likely lead to a reduction in air travel, particularly in the premium and long-haul segments that are the core of the wide-body market. This would directly impact engine flying hours, which are the primary driver of Rolls-Royce’s high-margin aftermarket revenues.

There is also considerable execution risk associated with the company’s ambitious strategic plan. While the initial phase of the transformation has been highly successful, delivering on the mid-term financial targets for profit, cash flow, and return on capital will require sustained operational excellence and cost discipline in a challenging environment.¹ Any failure to maintain the current momentum or a reversion to previous patterns of cost overruns could undermine investor confidence.

Geopolitical and Regulatory Headwinds

As a global aerospace and defense company with a complex international supply chain and customer base, Rolls-Royce is inherently exposed to geopolitical risks.³⁷ Escalating trade tensions, the imposition of tariffs on key materials like aluminum and steel, or the implementation of export controls could disrupt its manufacturing operations and increase costs.³⁶

Furthermore, the global push towards decarbonization, while an opportunity, also presents a significant regulatory risk. Governments, particularly in Europe, are implementing increasingly stringent environmental regulations and emissions standards for the aviation industry. These regulations could necessitate significant, and potentially unforeseen, R&D investments to ensure compliance. They could also accelerate the obsolescence of older aircraft and engine technologies, potentially impacting the value of certain assets on the company’s balance sheet and in its in-service fleet.

Valuation Assessment Framework

This analysis does not provide a specific price target or investment recommendation. Instead, it offers a framework for assessing the valuation of Rolls-Royce Holdings PLC, considering its unique position as a company undergoing a rapid transformation with a diverse portfolio of assets. A comprehensive valuation requires a multi-faceted approach, moving beyond simple peer comparisons to account for the distinct characteristics of each business segment and the long-term optionality embedded in its strategy.

Relative Valuation

A standard approach to valuation involves comparing Rolls-Royce’s trading multiples, such as forward Price-to-Earnings (P/E) and Enterprise Value-to-EBITDA (EV/EBITDA), to those of its direct peers: GE Aerospace, RTX (parent of Pratt & Whitney), and Safran.⁸ However, a simple comparison can be misleading. Rolls-Royce currently exhibits a significantly higher near-term earnings growth profile than its more mature peers due to the ongoing benefits of its turnaround. This higher growth could justify a premium multiple.

Conversely, the company’s historical and current operating margins, while improving dramatically, still lag the best-in-class profitability of a competitor like GE Aerospace’s commercial engine business.²¹ The central question for a relative valuation is whether Rolls-Royce can sustainably close this margin gap. If the market gains confidence that the 13-15% mid-term margin target is achievable and sustainable, a significant re-rating of its valuation multiples toward peer levels would be justifiable. The valuation discount or premium to peers will likely be a function of the market’s conviction in the durability of the transformation.

Sum-of-the-Parts (SOTP) Considerations

An SOTP analysis is a particularly useful framework for Rolls-Royce, given the disparate nature of its primary business segments. This approach involves valuing each division separately and then summing them to arrive at a total enterprise value. The logic for such a framework is as follows:

• Defence: This segment should be valued against high-quality, pure-play defense contractors. Given its long-term, government-backed contracts (B-52, AUKUS) and non-cyclical revenue streams, it should command the highest and most stable valuation multiple of the group.¹
• Power Systems: This division should be benchmarked against high-quality industrial peers. Its valuation will be sensitive to growth trends in its key end-markets, particularly the secular growth of data centers, which could warrant a premium multiple compared to more traditional industrial businesses.¹
• Civil Aerospace: This segment is best valued against its direct aerospace OEM peers. Its multiple will be heavily influenced by the outlook for long-haul international travel, the growth rate of engine flying hours, and the perceived sustainability of its high-margin aftermarket business.¹
• New Markets (SMR): This segment cannot be valued on traditional metrics as it currently generates losses. It is best viewed as a long-dated call option on the future of clean energy. Its value is not derived from current cash flows but from the probability-weighted potential of its future commercial success. Each new regulatory approval (like the GDA) and commercial agreement (like those with ČEZ and Vattenfall) de-risks the venture and increases the intrinsic value of this option.¹⁰

Intrinsic Value (DCF) Drivers

While a detailed Discounted Cash Flow (DCF) model is beyond the scope of this report, it is critical to identify the key assumptions that would drive such an analysis. The intrinsic value of Rolls-Royce is highly sensitive to a few key long-term variables:

• Long-Term Growth in Wide-Body EFH: The terminal growth rate assumption for long-haul air travel is a primary driver of long-term aftermarket revenue.
• Sustainability of Aftermarket Margins: The ability to maintain the improved profitability achieved through “commercial optimisation” is crucial. Any reversion to lower-margin contracts would significantly impact the valuation.
• Capital Intensity of SMR Commercialization: The magnitude and timing of capital expenditures required to build out the SMR manufacturing and deployment infrastructure will be a significant drain on cash flow in the medium term, before the business becomes self-funding.
• Success of UltraFan: The terminal value of the Civil Aerospace business is heavily dependent on the company’s ability to successfully bring its next-generation UltraFan technology to market to defend its competitive position on future aircraft platforms.

A thorough analysis must acknowledge the high degree of uncertainty inherent in these assumptions, particularly the timeline and ultimate profitability of the SMR business, which remains the largest source of potential upside and risk in the long-term valuation case.

Works cited

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