Image source: Rolls-Royce plc
Those who own Rolls-Royce Holdings (LSE:RR) shares might want to look away now. That’s because you’re probably not going to like what I’m about to say. Here goes… in my opinion, the aerospace and defence group’s shares are expensive. There, I’ve said it.
But those who are immediately offended and skip to the bottom of this article will notice that I have a shareholding in the company. Hypocrite or what?
Well, actually no.
In the world of stocks and shares, there are plenty of companies that attract lofty valuations.
For example, is Nvidia really worth £1.15bn more than all the members of the FTSE 100 combined? Or can it be justified that Tesla’s stock changes hand for 154 times more than its earnings over the past 12 months? Probably not.
In both these instances — and many more besides — the companies concerned have convinced investors that they each have great potential. And it’s the expectation that even ‘bigger things’ are round the corner that keeps their stock market valuations higher than might otherwise be justified by their current financial performance.
Best of British
It’s a similar story with Rolls-Royce. Based on its 2024 results, the stock has an eye-watering historic price-to-earnings ratio of 52. That’s why I opened by saying the group’s shares aren’t cheap.
However, its half-year results, which were released Thursday (31 July), contained another earnings upgrade. In fact, it was a rather big one. Previously, the group was forecasting an underlying operating profit in 2025 of £2.7bn-£2.9bn. It’s now expecting £3.1bn-£3.2bn.
And it’s this ability to keep growing that makes me retain my shareholding. The group describes all of its targets as “a milestone, not a destination, with substantial growth prospects beyond the mid-term”.
Even before yesterday’s results, its earnings per share was forecast to increase by 85% over the next four years. Based on the 2028 prediction, the multiple drops to a more reasonable 28.
Strong prospects
But I remain hopeful that the group will continue to beat these forecasts.
During the six months ended 30 June, 349 large engines were ordered. Each one will create a revenue stream for decades to come. Data centres and government contracts are helping its Power Systems division. Looking further ahead, the group says its small modular reactor programme (factory-built nuclear power stations) will be profitable and free cash flow positive by 2030.
But given the group’s generous valuation, any sign that things are cooling could see its share price fall sharply. The aviation industry is vulnerable to all kinds of disruption. Also, we’ve seen how engine problems can make investors nervous.
Interestingly, the group’s Defence division doesn’t appear to be growing as quickly as the rest of the business. This is, perhaps, surprising given how other companies with exposure to the sector seem to be doing so well.
Predictably, investors appeared impressed with the improvements in revenue, underlying operating profit and margin. The shares closed the day 8.5% higher.
So I don’t think I’m being hypocritical when — as a shareholder — I say Rolls-Royce shares are expensive. But I plan to hold on to mine because I believe the group can get close to (or exceed) the earnings forecasts that it’s set. For the same reason, other investors may want to consider taking a position.
