Image source: Rolls-Royce plc
What goes up must come down, as the old saying goes. As an aeronautical engineer, Rolls-Royce (LSE: RR) probably knows that better than most. Looking at the dizzying ascent of Rolls-Royce shares in recent years, though, it may be less than obvious. Over five years, the FTSE 100 share has soared an incredible 695%.
In 2022, Rolls-Royce shares performed better than any other company in the FTSE 100. Last year, it was one of the index’s top performers. So far this year, the share price has leapt a third.
Is there any limit to just how high the share can climb – and am I too late to get onboard and invest now?
The sky’s the limit
There is no actual limit to how high Rolls-Royce shares could go. In practical terms, though, there are a couple of key factors that will likely help determine where the share price goes from here.
One is momentum. When a share is popular, it can keep soaring, while when it is unpopular, it can drop time after time. In each case, the movement may not necessarily be connected to underlying business performance.
The other factor is that very business performance. Over the short- or even medium-term, share price performance can become detached from how a business is doing. Over the long run, though, business performance tends to be critical for how a share price does.
So, if the business does brilliantly, the sky could be the limit. Even if it does not do brilliantly, but investors remain captivated by it, the sky could be the limit for now. But sooner or later, the share price will likely fall back to earth based on the fundamentals of the business performance.
I reckon Rolls looks overvalued
When it comes to fundamentals, Rolls-Royce has been doing well.
Not only is it sticking with its ambitious medium-term targets, including those for this year. It recently said it still expected to deliver on its guidance for this year despite the potential impact of tariffs that have been announced so far.
However, although the business fundamentals remain strong, I think the valuation is now at a point that is hard to justify purely on those fundamentals. A price-to-earnings ratio of 27 looks too high for me, as it would give me very little if any margin of safety if Rolls turns out to disappoint.
That could happen. The tariffs may bite harder than the company expects. Companies could put off placing orders, delaying the recognition of revenues.
There are other risks too. A weakening economy could hurt passenger demand in civil aviation, potentially making airlines think twice before ordering new planes.
Meanwhile, the ever-present risk of an event that badly damages demand without warning – such as a pandemic or terrorist incident – hangs over aviation as always.
I do not think those risks are properly priced into the current price, so will not be adding any Rolls-Royce shares to my portfolio.
