Image source: Rolls-Royce Holdings plc
The performance of Rolls-Royce (LSE: RR) over the past several years has been incredible. In retrospect, Rolls-Royce shares were an enormous bargain when they were selling for pennies as recently as 2022.
They have come a long way since then though.
So, is the current Rolls-Royce share price still a potential bargain that makes me want to add the company to my portfolio?
What constitutes long-term value
A rising share price can make it seem like the earlier share price was a bargain. That is not always true. Sometimes, a share price can be unjustifiably high – yet still go even higher. Sooner or later,though, reality bites.
So when I am assessing whether to add a share to my portfolio, the question I ask myself is whether I expect to get more value from owning it over the long term than the price I pay now (allowing for the opportunity cost of tying up my money for years at a time).
A brilliant business?
At the right price, I would certainly be happy to add Rolls-Royce shares back into my portfolio.
The market for aircraft engines is valuable even with relatively small sales volumes, because of the high prices involved. Selling an engine is not even the main driver of value: typically servicing costs in the decades that follow end up being much higher than the initial purchase cost.
But few companies have the skills or equipment to make such engines. Rolls-Royce does and it also has a large installed base of engines it continues to service.
On top of that, it has a defence business that is benefitting from increased military spending by many European governments. Its power business also has potential for signficant growth.
Today’s share price offers a limited margin of safety
When deciding which shares to buy however, it is always important to consider whether the current price offers value.
Rolls-Royce shares trade on 24 times earnings. I regard that as too expensive for my tastes.
Now, the prospective value may be more attractive. The company has ambitious targets to improve its financial performance that could boost earnings per share markedly.
But for now, they are only targets. I see significant risks that could get in the way along the path, as has happened to the aeronautical engineer many times over its long existence.
US tariffs are one. Already some airlines have been floating the idea of delaying the delivery of new aircraft until the current tariff dispute ends.
Another is an event outside Rolls-Royce’s control that drives down demand for civil aviation and means airlines tighten their purse strings. That could be a big unexpected event such as a terrorist attack or pandemic. But it could be something less dramatic but equally damaging for aviation demand, such as a severe recession.
Looking back five years from now, Rolls-Royce shares may seem like a bargain today if things go very well.
However, considering the risks, I do not think the current share price offers me adequate margin of safety for my comfort level and have no plans to invest.
