Investing for explosive growth always comes with one core risk: the valuation. I’ve mentioned this problem before with the Rolls-Royce (LSE:RR) share price, but the investment just keeps on surging.
In fact, if I’d invested £1k in June 2022, I’d be sitting on roughly £5.2k today after a nearly 420% gain in price.
Business is strengthening
After a new CEO took the helm in 2023 after a disastrous pandemic period, the company began to shift its gears.
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Suddenly, the focus was not so much on growth but on efficiency. The business began selling off divisions that weren’t crucial and in high demand, and layoffs of up to 2,500 jobs began.
Management is executing this lean strategy in an effort to quadruple profits within four years. The evidence is mounting that this is working. Its recent year-on-year revenue growth was 22% compared to a five-year average of 2%. Earnings before interest and tax have grown at a staggering 142.5% year-on-year.
Are these results sustainable?
As with any business restructuring, a period of high growth doesn’t last forever. Instead, profits begin to plateau once management has maximised what it can.
Many analysts are still giving Buy ratings to Rolls-Royce and it’s clear that lots of investors want to get in on the action. However, it’s possible that towards the end of 2025, internal profit growth will start to slow, according to leading forecasts. This is likely to dampen shareholder returns.
This is a typical turnaround play, where management is looking to drive the share price higher through internal restructuring. Maybe the business will be able to maintain the high growth it’s presently delivering. However, in my opinion, most of the big share price gains have already been made.
Holding Rolls-Royce long-term
On the other hand, the company could surprise me and be more agile and innovative business-model-wise over time than I expect. If this is the case, it’s fair to assume that while the big profits have already been made, continued stable growth is on its way.
Yet it’s very hard for businesses with a lot of physical infrastructure to adapt quickly to market trends and opportunities. And selling off hangars and manufacturing divisions isn’t easy. A business may have to swallow big losses if it sells such items at a time when demand is low. Therefore, timing and strategy are crucial here.
Whatever the plan, I think that the shares will experience some price volatility soon. This is likely to come at the first sign of a contraction in earnings growth. If I then decide that I believe in the company’s long-term strategy, this would be around the time I’d consider buying.
I only say yes 20% of the time
The world-famous Pareto principle states that 20% of our investments are likely to generate 80% of our profits. I try to flip this on its head. I say no to 80% of the investment opportunities the market presents me with. That’s in an effort to lock in more money with the big opportunities.
I don’t feel confident enough to pull the trigger just yet on this one.
