Here’s why Rolls-Royce shares are now set to fly over the £4 mark

Once again, Rolls-Royce shares are crushing the FTSE 100. Should I add to my holding of this stock at the current valuation or leave it be?

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It seems like every week Rolls-Royce (LSE: RR) shares hit a new 52-week high. On 15 March, they did just that, briefly reaching 398p after yet more positive news.

The share price has pulled back to 390p, as I write. Yet that’s still an incredible 177% higher than it was just 12 months ago.

This is the sort of annual gain I’d expect to see from a Nasdaq software firm rather than a blue-chip FTSE 100 engine maker.

Here, I’ll look at what this latest good news was and consider whether the shares are now overvalued.

Credit rating upgrade

On 14 March, it was reported that Standard & Poor’s (S&P) had given an investment-grade credit rating to Rolls-Royce debt for the first time in four years.

The rating was raised to ‘BBB-‘ from ‘BB+’, S&P confirmed in a statement. It noted Rolls’s performance in 2023 had been stronger than anticipated, while increasing free cash flow should enable the company to cut debt.

S&P said: “We anticipate the company’s positive momentum will continue in 2024. Civil aerospace is set to continue its positive trajectory in 2024-2025, and the resilient defence business offers long-term visibility.”

This may now push Rolls-Royce shares above 400p if brokers start hiking their price targets. The share price consensus is 411p, around 5.4% higher than the stock is at now.

Furthermore, this credit rating upgrade is another step towards the reinstatement of dividends. I think that would be a symbolic moment given the perilous situation the company found itself in during the pandemic just four years ago.

Valuation

Up 30.4%, Rolls-Royce is the best-performing FTSE 100 stock so far this year. Has this left it overvalued?

The most up-to-date forecasts I can muster are for earnings per share (EPS) of 14.5p this year and 17.9p next year.

From this, we can quickly calculate the forward-looking price-to-earnings (P/E) ratio by dividing the share price by the EPS.

This works out at forward P/E multiples of 26.8 and 21.7, respectively. And on this basis, that makes the shares look quite a bit pricier than peers BAE Systems (19.1 and 17.4) and General Dynamics (18.8 and 17.1).

Of course, these are forecasts and this is just one valuation metric. It’s perfectly possible Rolls’s earnings could pleasantly surprise us, as they did so dramatically last year.

However, my gut feeling here is that I shouldn’t be buying more shares at this stage. They look fully valued to me, at least for now. I’d prefer to wait for a dip.

I’m holding on

That said, I’ve been waiting for one of those for months now, and there hasn’t been one. Quite the opposite, in fact, as discussed.

But this is an election year, so perhaps this will lead to a buying opportunity. Especially as Donald Trump, who has said he will stop funding the defence of Ukraine, could be elected.

If so, this might cause uncertainty around defence spending and lead to volatility in the share price. After all, Rolls-Royce’s defence division makes up around a quarter of overall group revenue.

Anyway, I’m holding onto my shares for now. But my eyes are peeled for the next (Q1) update, which is due 2 May.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Ben McPoland has positions in BAE Systems and Rolls-Royce Plc. The Motley Fool UK has recommended BAE Systems, Nasdaq, and Rolls-Royce Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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