Rolls-Royce (LSE:RR.) shares are down 3.5% this month, one of the most significant dips for the aerospace engineering firm in over a year of gains. If the price closes down this month it’ll be the first time in six months it closed lower.
But the decline isn’t particularly surprising. The share price recently touched £4.35, the highest it’s been in over 10 years. Having risen six-fold in the past 18 months, it’s hardly surprising that the stock is running out of steam.
And yet there are many reasons to believe it could keep going up.
The case for more growth
With Rolls-Royce still reporting high revenue there could be room for further gains. Throughout 2023, demand for its engines increased along with an increase in air travel. For now, there’s no immediate reason this trend will stop. It’s also seen increased demand due to defence spending related to the conflict in Ukraine. This is also ongoing.
Based on estimated future cash flows, the £4 price may be below fair value – by over 50%. Using a discounted cash flow model, analysts estimate a price of around £8.90 to be more fair.
Even with the rapid earnings growth in 2023, the trailing price-to-earnings (P/E) ratio of 13.7 is still well below peers. Similar aerospace and defence engineering firms like BAE Systems and Babcock International have higher P/E ratios. This reiterates the possibility that while Rolls-Royce is performing better than its peers, it may still be undervalued.
Of course, that doesn’t necessarily mean the share price will increase. Several factors could force a price reversal this year.
The case against more growth
Analysts evaluating the stock are in good agreement that earnings will decline this year. Subsequently, the company’s forward P/E ratio tells a different story. Estimated to reach near 27 times earnings, the current price would be less attractive.
So while performance so far has been impressive there are several arguments against further growth. Ironically, one of these also happens to be a reason Rolls saw increased demand recently – defence spending. Global conflicts are causing supply chain issues and increasing fuel costs, threatening Rolls-Royce’s bottom line.
With the conflict in the Middle East escalating further, there’s a possibility that supply disruptions will intensify.
Efforts to reduce debt and increase shareholder equity also continue. While the situation has improved somewhat since 2022, there’s still a way to go before it breaks even. Until then, Rolls has made it clear that dividends will remain on pause, limiting the stock’s value proposition. If the current growth momentum tapers off, investors may look to move money into more valuable investments.
BAE Systems, by comparison, has been paying a regular dividend for over a decade now.
My verdict
It’s a tough one to call.
On one hand, there’s a strong possibility that the shares will continue to grow. The recent dip could simply be the result of opportunistic profit-taking at a 10-year high. Alternatively, buyers may have dried up, fearing a lack of growth potential from such a high price level.
I’m one of those buyers – but whether or not I’m ready to sell is a different question. I believe a sustained fall below £4 could indicate an extended correction. Until then, I’ll hold and keep an eye on the price.
