Up 148% over the past year, the Rolls-Royce (LSE:RR) share price movements have been more akin to an exploding penny stock. Yet the rally has been tracking higher and higher, with the shares posting fresh 52-week highs almost every day.
This is fantastic, but it’s sensible to consider what could potentially cause a healthy correction lower in the stock. Here are three points I want to flag.
Relative value
The full-year results out last month showed that the business finally flipped from a loss after tax in 2022 to a profit after tax in 2023. This means that I can use the price-to-earnings (P/E) ratio to get a feel for whether the share price is good value relative to the earnings per share.
At the moment the P/E ratio is 27.56. This is high, considering that the FTSE 100 index has an overall P/E ratio of 10.34. Even when I look at the same sector, Rolls-Royce does look expensive. For example, BAE Systems has a P/E ratio of 20.19.
Therefore, investors could start to look at the stock rally and think that the stock is too expensive to justify buying it. If investors start to sell and put the money into undervalued FTSE 100 stocks, this could halt the rally.
Election risks
Although we don’t know the exact date of the UK general election, we do know that it’s going to be happening at some point this year.
Rolls-Royce will be sensitive to the result, given that it works with government for contracts. At the moment, it looks like there could be a change at 10 Downing Street based on the current polls. The uncertainty of a new party in power, along with potential changes in defence spending, could spook some investors.
Even if the speculation doesn’t prove to be correct, the stock could be a lot more volatile in the run-up to the election voting day.
Herd mentality
Finally, a good point was raised by the research team at Berenberg when they flagged up that positioning in the stock is “very crowded”. What this means is that because a lot of investors have piled in and bought over the past year and are in profit, any move lower could trigger a much sharper fall.
If the stock drops by a few percent, it could scare investors, causing more of them to sell. Given that people want to protect their profits, it could cause a spiral lower and lower as more people sell and follow the herd.
This isn’t a company-specific factor, but is certainly something to be aware of.
To be clear, Rolls-Royce has a lot of positive momentum going for it right now. The great set of financial results should help the company to push on in 2024. Therefore, although I don’t want to buy now, if we do see a correction lower, I’d use the dip as an opportunity to buy.
