Last year was an excellent one for Rolls-Royce (LSE: RR). The aeronautical engineer was the best performer on the whole FTSE 100 index. So, have Rolls-Royce shares struggled to maintain momentum in this year? Not at all. So far in 2024, the share has moved up 84%.
That means that, having sold for pennies just a couple of years ago, the share has now increased 121% on a five-year timeframe.
Can things just keep getting better, or is the price looking toppy?
Understanding how to value companies
Consider this. Is Rolls really worth 84% more than it was as recently as January?
Maybe it is.
After all, there is ongoing evidence of financial turnaround at the company after a difficult few years. That is inspiring investors with confidence that the engineer may achieve its ambitious medium-term targets.
However, I have my doubts. A lot (though not all) of what we see now was already apparent or could be predicted at the start of the year.
Relative to current earnings, Rolls-Royce shares now trade on a multiple of 20. That is at the top end of what I would typically want to pay even for an outstanding blue-chip company.
However, I would not pay that for Rolls, as history has shown – from pandemic-era travel restrictions to the aftermath of the 2001 US terrorist attacks – that demand for civil aviation engine sales and servicing can suddenly drop for reasons outside the company’s control, taking earnings down with it.
No margin for error
On the other hand, the prospective price-to-earnings ratio looks more attractive if one believes that Rolls can grow its earnings per share in coming years.
That did not happen in the first half of this year, when basic earning per share actually fell compared to the same period last year (though what the company terms underlying earnings per share grew strongly).
The business has been implementing a number of changes designed to improve its financial performance, from reshaping its portfolio of businesses to cutting costs. In its medium-term goals, the focus has primarily been on operating profit and cash flows. But if the business can improve them, then I expect that will also help lift earnings per share.
Still, Rolls-Royce shares seem to me to have come a long way in anticipation of that happening. That means there is little (or no) margin for error on the company’s part.
If it fails to meet the expectations fully, I think the dramatic rise that we have seen in the shares over the past couple of years could start to unravel.
Possibility of moving higher
However, for now that has not happened. In fact, if investor enthusiasm remains at its current levels, I reckon the Rolls-Royce share price might move even higher from here.
As a risk-conscious investor, though, I do not like the current valuation for a business history has shown can face sporadic significant external shocks. I have no plans to buy.
This post was originally published on Motley Fool
