Image source: Rolls-Royce plc
This has been a fantastic year for shareholders in aeronautical engineer Rolls-Royce (LSE: RR). This month, Rolls-Royce shares broke through the £10 price level for the first time in history (although they have since fallen slightly).
That reflects the incredible turnaround story at Rolls-Royce that has seen the FTSE 100 firm’s share price soar 969% in just five years.
That sort of performance is exceptional – and exceptionally attractive for many investors, including me. So, ought I to put some money into Rolls-Royce shares now, or am I too late?
Growing into its current valuation
Before considering whether the share may move even higher from here, it is worth pausing to ask whether the company even deserves its current price tag.
The current price-to-earnings (P/E) ratio for Rolls is 33. That looks high to me, especially for a company with a long history of mixed financial performance that operates in a mature industry.
Might it be justifiable, though?
Rolls has set out ambitious financial targets that mean its prospective valuation may be cheaper than the current P/E ratio suggests.
For example, by 2028 it expects to hit £4.2bn-£4.5bn of annual free cash flow. That would be 75%-88% higher than last year. Earnings and free cash flow are different, but this target helps demonstrate why investors remain excited about the potential at the company.
A target is one thing – but hitting it is another. Here, though, current management has so far performed well. Although the business operates in mature industries, it is reaping the rewards of elevated customer demand in all three of its key business areas: civil aviation, defence, and power generation.
If the business continues to perform strongly, the shares could grow into their current valuation, that I think is based partly on expectations about higher profits. That could potentially even justify a higher share price. Having hit £10, there is a credible case for the share to move higher still in the next few years.
Risk profile makes me uncomfortable
But although I can see a pathway to a higher price – and I reckon it is credible – for now I have no plans to buy any Rolls-Royce shares for my portfolio.
The reason is simple: I do not think the current share price reflects the risk profile in a way that makes me comfortable.
Take the external demand picture. I expect defence demand to stay elevated in coming years. Power generation may too, though that has sometimes become a faddish part of governments’ spending and large capital-intensive projects could be postponed if the economy is weak.
Civil aviation demand, as history has shown time and again, most recently during the pandemic, can slump overnight in a way that engine makers cannot impact, let alone control. That brought Rolls to its knees five years ago — and remains a critical risk in my view.
Meanwhile, I see some other risks. Almost doubling free cash flows is great – but where will the money come from? Cost savings can only go so far.
If the company pushes prices up too much, customers may shop around more. There are not many engine makers – but there are some, and large airlines know how to drive a hard bargain.
