Are Rolls-Royce shares a bubble waiting to burst in 2025?

Holders of Rolls-Royce (LSE: RR) shares enjoyed another brilliant return in 2024. But does an arguably-frothy price tag mean that this is now a bubble primed to pop in 2025?

Let’s take a closer look.

Stunning gains

From a low of around 39p a pop in October 2020 to almost 587p a little over four years later, Rolls-Royce has clearly been the UK stock to back. In stark contrast to that multi-bagging magic, the FTSE 100‘s up around 40%. Yes, anyone holding a fund tracking the latter would have seen some dividends on top of this. But that barely reduces the gap in performance.

A lot of this turnaround must surely be attributed to CEO Tufan Erginbilgiç. Under his stewardship, the company’s slashed costs and improved operational performance.

Yes, there have been wobbles along the way. Back in November, a number of airlines announced they had been forced to cancel flights due to engine maintenance not being completed on time, for example. But the market’s clearly been willing to shrug these off.

Stick or twist?

The problem holders face is deciding whether Rolls-Royce shares can motor even higher given it already trades at a forecast price-to-earnings (P/E) ratio of 28 for FY25.

Now, that valuation isn’t necessarily excessive. Some top-tier stocks change hands for even greater earnings multiples. And Rolls-Royce looks almost cheap when lined up against some of the US tech titans.

Investors can also find plenty of reasons to be bullish. The order book’s strong, margins are expanding and debt’s falling. The company also has some diversification in the form of its defence and power systems divisions.

Although negligible for now, the reintroduction of dividends after a long absence is another positive sign. No management team would want to do this unless it was very confident it wouldn’t need to go back on its word.

But there are a few things I’m struggling to overlook.

Bring out the bears

Rolls Royce’s market capitalisation now stands at £50bn. It’s going to take some awfully good news flow for shares to double again (as they almost did in 2024). Out of interest, full-year numbers are due on 27 February.

Tellingly, the firm’s price/earnings-to-growth (PEG) ratio comes in at 1.7. As a rough rule of thumb, anything lower that 1.0 on a stock could indicate I’d be getting quite a lot of potential bang for my buck. Anything over… not so much. Naturally, that ratio’s based on analyst earnings estimates that may prove to be wide of the mark.

Away from the numbers, Rolls-Royce’s fortunes are still heavily tied to the aviation industry and global travel demand. Yet more geopolitical instability could reduce the latter, as might a recession. Supply chain issues could also get worse.

Staying grounded

Taking the above into account, I don’t believe Rolls-Royce shares are in a bubble in the traditional sense. This is a classic turnaround story of a business that now generates far better numbers than it once did. But I’d also be pretty surprised if its stock replicated last year’s magnificent gain in 2025. If the price does rise, I’d say we’re looking at something more modest.

Considering that valuation, I think there might be better opportunities to consider elsewhere in the UK market.

This post was originally published on Motley Fool