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As I write, Rolls-Royce (LSE:RR.) shares have convincingly smashed through the 900p barrier and are trading at an all-time high. The iconic aerospace and defence company is now the sixth most valuable company in the FTSE 100 index, with a market cap just shy of £77bn.
Following the spectacular 709% rally for the Rolls-Royce share price over five years, have new investors missed the boat? Or can the shares continue to climb higher from here?
Here’s my take.
Nuclear boost
Since CEO Tufan Erginbilgiç took the helm at Rolls-Royce in January 2023, shareholders have become accustomed to fabulous earnings reports.
Some highlights include a £1.8bn improvement in operating profit since 2022 to £2.5bn, and an operating margin of 13.8%, compared to 5.8%. From civil aerospace to defence to power systems, the business is firing on all cylinders.
And the good news keeps on coming. Energy Secretary Ed Miliband just announced a massive investment in Britain’s nuclear energy infrastructure.
Fending off competition from three overseas companies, Rolls-Royce has been selected by the government as the first firm to build small modular nuclear reactors (SMRs) in the UK. Over the current spending review period, £2.5bn of public funds have been earmarked for SMR construction.
These small-scale nuclear fission reactors offer greater flexibility than traditional large-scale nuclear power plants. Their typical footprint is only the size of two football pitches, and they’re cheaper and quicker to build.
The SMR projects will be executed by an independent business called Rolls-Royce SMR, but the company’s majority stake is owned by Rolls-Royce. Accordingly, shareholders in the FTSE 100 firm stand to benefit from the green light given to build three SMRs in the UK, with the potential of more to come.
Rolls-Royce SMR is a pioneer in this fast-growing space. It’s 18 months ahead of the competition, and Erginbilgiç expects its value will “grow materially” over the coming years.
Valuation risk
It’s easy to be exuberant about Rolls-Royce shares with so much positive news flying around. However, the company’s current valuation might be sobering for some would-be investors.
A forward price-to-earnings (P/E) ratio above 37.7 puts the stock well above the average for FTSE 100 companies. In addition, a price-to-sales (P/S) ratio of nearly four suggests that the shares could be overvalued. Usually, analysts like to see a number below one when looking for a value investment opportunity.
At these sky-high multiples, the stock’s priced for perfection, and there’s scant room for error. Growth has to live up to expectations. Granted, Rolls-Royce has a wide moat, but even a small earnings miss could send the shares plummeting.
It’s still a thumbs up for me
I own Rolls-Royce shares, but my entry point was significantly lower than today’s price, with an average cost per share of 142p. I’m comfortable with my present exposure, so I won’t be buying more today, but I won’t be selling either.
For investors who don’t own the stock, it’s still worth considering. The business is one of the most dynamic growth opportunities in the FTSE 100, and I’m hugely impressed with the management team.
That said, at today’s valuation, it’s not the bargain it once was. New investors would be wise to avoid overexposure via portfolio diversification.
