Rolls-Royce (LSE:RR.) shares have been a brilliant investment recently. This year alone, they’ve risen about 80%. Sadly, I’ve missed out on these blockbuster gains as I don’t own the shares. The question is – is it worth buying them for my portfolio for 2025?
Growth potential
I’m going to focus on three key factors in this analysis – growth, quality, and valuation. These factors should give me an idea of whether the stock could be a good buy for my portfolio.
Starting with growth potential, there are certainly reasons to be optimistic here. You see, Rolls-Royce is a diversified company these days. Today, it operates in multiple industries including civil aerospace, defence, and power generation (including nuclear energy).
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The power generation segment looks particularly interesting to me. Here, the company’s having success providing power systems to data centres (a huge growth market).
The nuclear energy segment also looks interesting. Here, Rolls-Royce is developing small modular reactors (SMRs) and micro nuclear reactors.
Given that Big Tech companies are turning to nuclear to power their data centres, Rolls-Royce could have success with these products. There are no guarantees though – it’s still early-stage technology.
As it stands however, City analysts are expecting revenue growth of 8% next year. That’s a decent level of top-line growth.
Quality analysis
Quality’s important to me. I like to invest in companies that have strong competitive advantages, high levels of profitability and cash flow, rock-solid balance sheets, and good track records in terms of generating shareholder wealth.
Now in the past, I viewed Rolls-Royce as a low-quality company. While it had some competitive advantages (barriers to entry in the commercial aircraft engine market are high), its balance sheet was a mess and its profits were all over the place.
Things have really improved under CEO Tufan Erginbilgic however. Looking at the balance sheet, net debt was just £0.8bn at the end of H1. And profitability’s rising. In H1, return on capital increased to 13.8% from 9% a year earlier.
Dividends are coming back too due to the fact that the company’s now generating a lot more cash. So there’s definitely more quality here now than there was in the past.
Any value left?
Finally, we have the valuation. This is where things get complicated. Next year, analysts expect Rolls-Royce to generate earnings per share of 21p. So at today’s share price, we’re looking at a forward-looking price-to-earnings (P/E) ratio of about 26.
That’s a high earnings multiple and it doesn’t leave a lot of room for error. If the company experiences some challenges (eg supply chain problems, a loss of a key customer, etc) and growth’s disappointing, the stock could take a significant hit.
One other thing worth mentioning here is that the stock’s up more than 500% over the last two years. After that kind of rise, a risk is that we could see some profit taking (and share price weakness) in the near term.
Should I buy?
Given the big rise in the share price and the high valuation, I don’t plan to buy Rolls-Royce shares right now. To me, the risk/reward set-up isn’t particularly attractive.
I will keep the stock on my watchlist though. If the share price falls, I could be more interested in buying.
