Since the start of the year, investing in Rolls-Royce (LSE: RR) has been a rewarding choice. Rolls-Royce shares have increased by 50% so far in 2023, although they are still 49% down over five years.
But that gain basically came in the first two months of the year. By early March, they had already reached the price at which they currently trade. Since then, the shares have basically been treading water, mostly trading between £1.40 and £1.60.
Are they in a holding pattern before another big leg up? Or could it be that investors think the company’s prospects are now fully priced into the price of Rolls-Royce shares?
Upbeat statement
The reasons for the share price jump include optimism about increased demand for aircraft engine sales and servicing as travel demand booms, alongside the benefits of a cost-cutting programme.
This week, Rolls had its annual general meeting. The company noted: “Our financial performance is improving reflecting positive changes driven by our transformation programme workstreams and good end market demand for our products and services”.
I see that as positive as it effectively reinforces the investment case that has already propelled Rolls-Royce shares higher.
The firm maintained its guidance for the current financial year. That includes an underlying operating profit of £0.8bn-£1bn and free cash flow of £0.6bn-£0.8bn.
Valuing Rolls-Royce shares
That is positive news. After the heavy cash burn of the pandemic years, for the aeronautical engineer to be generating a sizeable operating profit and free cash flow once more is encouraging.
But what do those figures mean for valuation? After all, the current market capitalisation stands at £12.5bn. That is between 16 and 20 times the forecast free cash flow for the year.
As to the company’s price-to-earnings ratio, it could be even higher than that. The operating profit figure is encouraging, but operating profits and earnings can be wildly different. Rolls made an operating profit last year of £0.8bn. But at the earnings line, it reported an after tax loss of £1.2bn.
Whether using earnings or free cash flow, in the short term I think the price of Rolls-Royce shares already factors in expectations of improving performance.
The valuation definitely does not look like a bargain to me. At points in 2020, the shares traded below 40p each. Their high point this year is four times that much.
Waiting for take-off
As I do not own Rolls-Royce shares, I am not worried if they now lose to start altitude.
However, as I think the valuation is reasonable, I see no reason for them to fall sharply unless the company changes its guidance. Travel demand is high. Multiple airlines including Ryanair have recently announced massive orders for new planes. But there is always a risk that some unexpected event could lead air travel to drop overnight, hurting servicing revenues for Rolls.
However, as I think the price of Rolls-Royce shares factors in expected performance, I see no reason for them to gain a lot more ground in the short term in the absence of increased profit guidance.
For now, the company needs to deliver on its plan. If that plan stays roughly the same, I do not see a driver for a sharp price increase. At this point, I have no plans to invest.
