Last year was a stellar one for investors in Rolls-Royce (LSE: RR), as the aeronautical engineer was the best performing among all FTSE 100 shares. This year too, the Rolls-Royce share price has performed strongly. The share has soared 39% in a matter of months.
Over the past month however, the momentum seems to have flagged somewhat.
The share has been flirting with prices around £4 and for now at least seems to be in a holding pattern close to that marker. What might it mean?
Time to grow into the valuation
I think the Rolls-Royce share price is taking a breather, waiting for business performance to catch up. After all, this is a share that has shot up 170% in price in the past year alone.
Having done that, it is now time for the company to show it merits that valuation. If it can do that, I think the upwards momentum could start again.
But if it does not, maybe because it shows weak progress on its ambitious medium-term performance targets, I think the price might slide.
The business is doing well
For now, at least, the signs are looking promising for an ongoing strong business performance at Rolls.
Last year, statutory earnings per share were 29p. Not only is that a big turnaround from the prior year’s statutory loss of 14p per share, it also helps support a Rolls-Royce share price of around £4, in my view. At that level, the current price-to-earnings ratio is 14. That strikes me as reasonable.
If future earnings grow, the price could move up. But Rolls has a long history of inconsistent earnings from one year to the next. That reflects a variety of factors, from large deals booked in a given period (aircraft engines are not cheap) to sudden slumps in demand caused by an event like the 2001 terrorist attacks or the pandemic.
For now though, I think the recent pause in share price gains reflects the fact that the business has its work cut out to keep improving its performance as it has done in the past year or so.
Things could still take off from here
Will that happen? I think it might. I reckon a significant part of last year’s improved results reflected a shift in civil aviation demand and internal cost-cutting. Both were already in progress before the company’s current growth strategy kicked in.
If those trends continue – and the strategy is delivered to boot – earnings could grow. That might merit a higher Rolls-Royce share price.
In a holding pattern
For now though, I have no plans to invest. I think the shares could move higher, but I do not think the current price offers me much margin of safety.
We have seen in the past that Rolls-Royce (and competitors such as GE Aerospace) are subject to sudden dramatic demand swings that lie largely outside their control.
That risk is significant, in my view, so at the current share price, I am not tempted to buy.
