Image source: Rolls-Royce plc
The past week was yet another good one for Rolls-Royce (LSE: RR) shareholders. For the umpteenth time in recent years, the Rolls-Royce share price hit a new all-time high.
Its track record now really is a thing of wonder. At the end of 2022, the share was selling for pennies. But it is now well north of £8, having soared 777% over the past five years (fittingly for a company that makes Trent 800 engines for the Boeing 777!)
Clearly, the share has had phenomenal momentum. I happen to like a lot of elements of the Rolls-Royce investment case. But is it really sensible for me to invest at this sort of price level?
Strong business with good prospects, but is that all?
I understand why the share has soared in recent years. Rolls-Royce is a well-respected manufacturer in a large industry that looks set to hang around for decades and has high barriers to entry. Rebounding civil aviation demand combined with increased European defence expenditure have both been strong external factors in Rolls-Royce’s recovery.
But it has been internally driven too, with aggressive financial performance goals met years early and even more ambitious ones now in place.
Still, before even getting onto valuation, it is worth noting that Rolls-Royce operates in a variety of mature industries. That does not mean they lack growth prospects, as we have seen lately. But that growth will likely be incremental not exponential over the long run.
Rolls-Royce is a good business now, but it has a long history of very mixed performance. That partly reflects the economics of its industry, with high fixed costs, decades-long investment cycles and cyclical demand from airlines.
Do I think it is a good business? Yes. But do I think it is eight times better as a business than it was five years ago? No.
I don’t like this valuation at all
So why has the Rolls-Royce share price soared? Undoubtedly, improved business performance and outlook has been key. Momentum-led investor enthusiasm has likely played a role too.
But I also think some exuberance has set in, as investors take an approach to pricing risk that is different to mine. Rolls-Royce was on its knees five years ago because an unexpected sudden slump in civil aviation demand decimated engine sales and servicing revenues, but was totally outside the company’s control.
Such a risk has always been there for Rolls-Royce and its rivals – and I believe it still is. From travel restrictions to a pandemic, a war to volcanic eruptions, civil aviation occasionally goes through a massive external shock.
That risk has not changed, but the Rolls-Royce share price has. Now trading for 28 times earnings, it looks overpriced to me.
I recognise that if it delivers on its financial goals, earnings per share should rise, meaning the prospective price-to-earnings ratio is lower than 28. That could potentially support even more upwards movement in the share price.
However, the risk-to-reward balance here makes me uncomfortable and I have no plans to invest.
