It has been a challenging few years for aeronautical engineer Rolls-Royce (LSE: RR). But lately, the Rolls-Royce share price has been on a roll.
It hit its highest level since before the pandemic (over five times their 2020 low). But on a five-year outlook it is down by a third. The dividend remains suspended.
With recent price action suggesting many investors are feeling highly bullish on the outlook for Rolls-Royce, could now be the time for investors to buy the shares?
Long-term potential and short-term results
Based on current business performance, I already think the share price looks high.
The market capitalisation is £19bn. The company has net debt of £2.9bn (which is lower than before, but still a lot) and forecasts an operating profit for the full-year of £1.2bn-£1.4bn. That is a sharp improvement on recent form. But it still suggests a prospective price-to-earnings ratio of 14 or above, even excluding non-operating costs like taxes and debt repayment.
For a company with a highly inconsistent recent track record when it comes to earnings, that valuation does not look cheap to me.
So why has the share price kept rising this year? I think it is because investors are valuing the shares based on what they see as the firm’s future prospects.
With global aeroplane demand growing again and existing planes flying more than they did during the past few years, both sales and service revenues at the company could climb steeply.
On top of that, its defence division is performing robustly and could benefit from more spending by many governments.
Understanding the risks
On that basis, the share could still offer a potential bargain.
If the company is able to continue its turnaround in coming years, grow sales, and improve its profitability, it could end up meriting an even higher price than it currently has.
However, I also see risks – including some fairly substantial ones.
There is an executional risk that the wheels could come off the turnaround plan. Although travel demand is high, the global economy looks weak. That could lead airlines to rein in their expenditure plans for pricy new planes.
Long-term outlook
There is also a systemic risk that the pandemic highlighted but did not directly create.
Rolls-Royce’s business is heavily reliant on civil aviation spending. But that can suddenly fall off a cliff with little warning. It happened as travel restrictions were introduced during the pandemic. But the same sort of thing had occurred after the 2001 terrorist attacks. A decade before, the trigger was the Gulf War, while the 1970s oil crisis had a similar effect.
That sort of cyclicality is something that puts me off buying into Rolls-Royce.
It may be five, 10, or more years – but sooner or later I expect some other sudden event may lead to a big fall in demand for engine servicing and sales.
That could send the Rolls-Royce share price crashing down again. As a long-term investor, therefore, at the moment I have no plans to buy the shares.
