Rolls-Royce (LSE: RR.) shares are on fire. Year to date, they’re up about 120%. Are they the best buy on the FTSE 100 index right now, given their current momentum? Let’s discuss.
Profits are taking off
Looking at Rolls-Royce today, there’s a lot to like about the company from an investment perspective.
For a start, the company’s profits are rising sharply, thanks to the recovery in the booming civil aerospace market as travellers make up for lost time during Covid.
Recently, the group reported underlying operating profit of £673m for the first half of 2023 – more than five times the level a year earlier.
It also raised its full-year profit forecast to £1.2bn-£1.4bn from a previous guidance of £800m-£1bn. The consensus forecast at the time was around £930m.
On the back of these results and guidance, brokers have been scrambling to raise their earnings forecasts for the group. Over the last month, the consensus earnings forecast for 2023 has risen by about 0.9p to 8.4p. Meanwhile, the forecast for 2024 has climbed by 0.9p to 10.4p. This kind of positive broker activity tends to push a stock upwards.
A stronger business
Secondly, the company is undergoing a major transformation programme. And this appears to have room to run.
“Our multi-year transformation programme has started well with progress already evident in our strong initial results and increased full year guidance for 2023. There is much more to do to deliver better performance and to transform Rolls-Royce into a high performing, competitive, resilient, and growing business,” CEO Tufan Erginbilgic said recently.
That said, Erginbilgic warned that while the programme has been delivering strong improvements, it would not keep delivering at the same rate. “Rate of improvement is not linear therefore shouldn’t be extrapolated, because early on, rate of improvement is normally high,” he said on a call to analysts.
Share price momentum
Finally, the shares are in a strong upwards trajectory right now. In my view, investors are much better off buying stocks that are trending up over those that are trending down. That’s because such trends often last for a while.
The best FTSE 100 stock to buy?
However, while there’s a lot to like about Rolls-Royce, I’m not convinced the stock is the best buy on the FTSE 100.
One issue I have, as a long-term investor, is that the company has a patchy track record in terms of growth and profits. So its current momentum may not last.
Another is that in recent years, the group hasn’t generated a high level of profitability (a high return on capital). Generally speaking, the best-performing companies in the long run are those that can consistently generate high returns on capital (these types of companies tend to get much bigger over time).
Additionally, the company’s balance sheet is a little weak. At 30 June, it had net debt of £2.8bn on its books. This makes the company vulnerable due to the interest payments required to service this debt.
Add in the fact that the valuation looks a little high now (the forward-looking price-to-earnings ratio is about 21) and I think there are better FTSE 100 shares to buy right now.
