Since May 2023, the Rolls-Royce (LSE:RR.) share price has risen 175% resulting in a current stock market valuation of £35.4bn. In my view, the engineering firm’s lofty market cap means its stock is on the verge of become a joke.
A funny feeling
But I take investing seriously. That’s why I usually avoid penny shares. They are too risky for me and just don’t make cents.
Some say the safest way to double your money on the stock market is to fold it in half. And that the best method of making a small fortune is to start with a large one.
But I disagree.
By following some basic principles I think it’s possible to accumulate significant wealth. And one of my rules is not to invest in expensive stocks. And, as much as I’m a fan of Rolls-Royce as a business, I think its shares are overvalued.
The consensus of analysts’ forecasts for the year ending 31 December 2024 (FY24) is for earnings per share (EPS) of 19.1p. This means the stock is trading on a multiple of 22 times current earnings. According to Siblis Research, the forward price-to-earnings (P/E) ratio of the FTSE 100 is 10.65.
But the ‘experts’ are expecting the company’s earnings to grow over the next few years as its civil aviation business benefits from a post-pandemic recovery and global conflicts help its defence division. By FY27, EPS are forecast to be 26.5p. Using this figure, the company’s forward P/E ratio is a more modest 15.7.
But this is still nearly 50% above the Footsie average, which is why I think the stock is overvalued.
Bulls and bears
However, when it comes to investing, opinions differ. It’s a curiosity that every time one person sells another buys, and yet both think they are being clever and doing the right thing. This illustrates that nothing is certain in the world of investing. If you want a guarantee, buy a toaster.
That’s why, when choosing stocks, I take into account analysts’ views. And no, that’s not because they will know tomorrow why the things they predicted yesterday didn’t happen today.
Of the 17 analysts covering Rolls-Royce, 13 rate the stock as a ‘buy’, three are neutral and one is advising their clients to sell. I’m clearly in a minority here.
Despite what I think, the Rolls-Royce bull run shows no sign of coming to an end. Those who bought shares in October 2020, when they reached a post-Covid low of 39p, are probably laughing all the way to the bank.
Don’t get me wrong, I’m a big fan of the company. I think it has a strong brand and an excellent reputation for engineering quality.
A few years ago, it built a device to fire dead chickens at its engines to test their strength. Some competitors thought it was a great idea and used the gun for similar tests on their own versions. But the chickens caused huge damage. The horrified testers sought advice from Rolls-Royce on how they could improve their engines. The company issued a simple one-line response: “defrost the chickens”.
Seriously though, only time will tell whether I’m right about the company’s current stock market valuation. And who knows, in a few years I might be laughing on the other side of my face.
