Rolls-Royce (LSE: RR) shares have been on an impressive run for some time now. The company’s valuation has surged thanks to strong profit growth and ongoing demand across key industries including power systems and defence.
The price has almost doubled in the past 12 months alone and sits at £5.86 as I write on 17 January.
The gains haven’t been a flash in the pan either. A valuation increase of over 500% since the start of 2023 have propelled the group’s market cap to nearly £50bn.
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With this recent growth and momentum, I thought I’d evaluate the company’s recent performance and several things I’d consider before buying.
Strong 2024 performance
Investors weren’t purchasing Rolls-Royce shares on a whim last year. The company’s strong share price gains were fuelled by robust financial results and achievement of key strategic priorities.
Half-year underlying operating profit of £1.1bn and underlying operating cash flow of £1.2bn were reflective of strong operational results and ongoing value creation in both new and existing markets.
Management also raised full-year guidance despite supply chain challenges, with forecast underlying operating profit of £2.1bn-£2.3bn and free cash flow of £2.1bn-£2.2bn.
Investors should also be pleased to see the reinstatement of shareholder distributions. The company is expecting to start with a 30% ratio of underlying profit after tax, with an ongoing payout ratio of 30%-40%.
Valuation
I’m always asking myself whether a company is overvalued, undervalued or just about the right price. I think that’s especially important for Rolls-Royce given the charge the shares have been on recently.
Let’s start with price-to-earnings (P/E) ratio. The stock is currently trading at a multiple of 21.2 which is at a premium to the FTSE 100 average of around 14.5. That in itself is not an issue, as P/E ratios will vary by industry.
For instance, investors might be more willing to pay for a defensive company compared to those in cyclical industries.
Nevertheless, Rolls-Royce looks a touch expensive. BAE Systems has a P/E ratio of 20.3 as I write, while across the Atlantic Lockheed Martin trades at around 17.6.
The reinstatement of dividends, upgraded full-year guidance and strong free cash flow generation are certainly factors. However, I’m wary of buying the stock at the current level despite a generally positive outlook.
Risks and opportunities
The company itself hasn’t shied away from the supply chain challenges it’s facing at the moment. Continued disruption could impact on production and costs, hurting margins and profitability.
International relations are delicately poised as we enter 2025. Any further shocks or unexpected moves from the incoming Trump administration could have serious impacts on defence spending and contracts.
On the plus side, Rolls-Royce may benefit from deglobalisation and efforts to bolster national security across the globe.
If management can continue to execute its strategic objectives and keep costs under control, shareholders could reap the rewards.
Verdict
There are several things I think investors should consider before buying Rolls-Royce shares. While I wouldn’t be surprised to see the company’s share price climb higher, I won’t be buying.
The stock looks a touch expensive and exposed to a fragile geopolitical environment. I’m more interested in defensive industries like pharmaceuticals to complement my current portfolio.
