Image source: Rolls-Royce plc
At first glance, even the idea of Rolls-Royce (LSE: RR) offering a stock market bargain right now may seem laughable. After all, the Rolls-Royce share price is already up 52% so far this year and has been trading close to record levels.
Over five years, it has risen a staggering 677%.
But could it still be a smart buy for my portfolio even at its current level?
Success can breed success
An important thing to understand about this situation is that the Rolls-Royce share price has not been moving like that for no reason.
Five years ago, the business was on its knees. Civil aviation demand had slumped, the company was bleeding cash and it diluted existing shareholders by selling more shares to raise cash.
Part of the reason the Rolls-Royce share price has recovered sharply is that the civil aviation demand picture has since been transformed. With people flying again in large numbers, airlines have been servicing existing engines regularly as well as buying new ones.
But that is not the only reason Rolls shares have soared. Defence spending has increased markedly, lifting defence shares including this one. The company’s power systems division has also been doing well, something that looks set to last.
Meanwhile, the company has made moves of its own that help explain the share price growth. One is aggressive cost-cutting. Another has been setting aggressive medium-term goals for financial performance. If reached, this could help justify a premium valuation for the company. The better Rolls has been doing, the healthier it has looked financially – paving the way for more success in future.
The best could yet be to come
On that basis, I reckon that even now, Rolls-Royce shares could be a bargain. This month, a non-executive director bought 2,837 of them with her own money.
Should I do the same?
Having hit some goals early, the company has raised them. That could create more value.
It is benefiting from elevated demand in all three of its business areas. A price-to-earnings ratio of 30 looks expensive to me. But by 2028 the company is targeting £3.6bn-£3.9bn of underlying operating profits annually.
That is not the same as profit (as there are non-operating elements to consider, like financing and investing) but the current market capitalisation is around 19 times that number (at the top end of the estimate).
So if Rolls-Royce delivers, the current share price does not look wildly expensive to me. If it can deliver on those targets, it may set higher ones, making the current price look even more attractive to a long-term investor.
Still, there is a lot that remains to be proven. Setting a goal is one thing, achieving it is another.
Civil aviation demand is occasionally thrown into a slump by anything from war or terrorism to a recession or pandemic. That risk remains high in my view and I do not think the current Rolls-Royce share price offers me enough margin of safety to account for it.
Therefore, although I reckon the price could move up even from here, I will not be buying.
