Unless you’ve been living under a rock for the past year, you’ll be aware of the mega rally in the Rolls-Royce (LSE:RR) share price. The 135% jump over the last year means the stock now trades at 487p.
Yet last week, US bank JPMorgan‘s research team upgraded its forecast for the firm. Its analysts indicated that more gains could be coming. Is this realistic?
Shooting for the moon
In a note put out last week by the bank’s analyst David Perry and his colleagues, the share price target for the next year was increased from 475p to 535p. This isn’t a guarantee that the stock will trade at that price, but rather reflects the analyst’s viewpoint.
Perry flagged up that part of the reason for the increase was the strong set of recently-published H1 results. In them, underlying operating profit soared from £673m in H1 2023 to £1.15bn this time. This reflected “the impact of [the] strategic initiatives, with commercial optimisation and cost efficiency benefits across the group”.
Another reason for the share price forecast hike was the increase in free cash flow. Perry explained that the likely boost to free cash flow over the coming year should be due to higher profits, rather than customers simply paying in advance for their orders. Therefore, the cash flow increase is actually good quality rather than just an accounting point.
Why I’m more cautious
I take the price adjustment from JPMorgan seriously and agree with the points made from the strong set of recent financial results.
However, I’m slightly more cautious given that the stock’s now at record high levels. I wrote recently how I was being patient and waiting for a correction lower, at which point I’d look to buy. This hasn’t materialised yet, but I don’t want to jump in with the share price close to 500p.
With a price-to-earnings (P/E) ratio of 35, the stock certainly isn’t undervalued. With my fair value benchmark of 10, I just don’t think buying right now makes sense. Of course, there’s a chance that the stock stays at a high P/E ratio for a long time. This is something I have to accept might happen.
Further, the business flagged up a “challenging supply chain environment” which could pose a risk going forward.
Keeping an eye on things
Don’t get me wrong, I think the firm is well positioned for the long term. The transformation under CEO Tufan Erginbilgiç has been remarkable. But just because I like a company doesn’t mean the stock represent a smart investment right now.
So although some brokers are increasing their price target, I’m going to sit on my hands. In doing so, I’ll try to wait and buy the stock at a more reasonable valuation.
