The performance of Rolls-Royce (LSE: RR) over the past several years has been simply phenomenal. The Rolls-Royce share price, under 40p in 2020, has recently been close to £6.
It has now fallen back slightly to trade at around £5.50. But I reckon it could get back up to and pass the £6 mark. In fact, I would not be surprised to see it go past £7 in 2025.
Momentum and fundamentals
A couple of different things affect share prices, depending on the situation.
One of them is the fundamental, underlying performance of the business. I will discuss Rolls’ fundamentals in just a moment.
But momentum can also be important.
As investors (and perhaps speculators) who fear missing out, they keep piling into a hot share, pushing it upwards. That can last a long time but equally can suddenly go into reverse.
Momentum largely ignores fundamentals on the way up – but the same can be true on the way down, too.
Even a strong business can see its share price fall in the short to medium term if enough investors fall out of love with it (or simply opt to cash in their gains to spend on something else).
I like the look of the business, if things go smoothly
So, I think momentum alone could push the shares to £6. That may even be true up to £7, although that will be harder.
But as a believer in long-term investing, not a trader, my interest is not in momentum but rather in the fundamentals that ought to underpin the Rolls-Royce share price over the long run.
At £6, the prospective price-to-earnings ratio would be nearly 22, and at £7, over 25. Those look high to me.
However, that is based on the company’s current earnings. But imagine Rolls can double its earnings.
That may sound ambitious. But at the half-year point, basic earnings per share were 83% higher than in the same six months last year.
Not only that, but Rolls is still only on the road to meeting its ambitious medium-term financial targets. If it manages to do that and earnings rise accordingly, I think £7 would be a reasonable valuation for the share.
I’m not ready to board!
Despite that – a 27% potential jump from the current Rolls-Royce share price – I will not be buying.
Why not?
The targets are ambitious and Rolls has a long history of mixed performance. Some of that is within the company’s control. But some key elements are not.
For example, demand for civil aviation engine sales (and, to a lesser extent, servicing) can plummet when people stop flying en masse, for example because of terrorist fears or pandemic-related travel restrictions.
I expect such demand shocks to happen again at some point. They lie outside the company’s control. Maybe its nuclear power and defence businesses will help absorb the shock, but civil aviation is core to the company.
I do not think the current share price, let alone a higher one, offers me sufficient margin of safety to reflect that risk properly.
