For a mature company listed on the stock market for decades already, Rolls-Royce (LSE: RR) has a very unusual share price chart. Rolls-Royce shares have soared 51% so far this year. They are now 692% higher than five years ago.
In recent years, it has seemed as if the Rolls-Royce share price has just got higher and higher. There have been bumps along the way, but the momentum has been strong.
So, might it make sense for me to buy some today for my portfolio?
Looking at future fundamentals, not past momentum
To start with, I ought to be clear that I do not invest based on a share’s momentum. I see it as a bit like pass the parcel: once the music stops, the mood can change very quickly.
So my choice about whether to buy Rolls-Royce shares for my portfolio is based on how the business’ commercial prospects look, not what the share price has been doing.
Room for ongoing growth
In short, I think the Rolls-Royce looks well-positioned for the short- to medium-term future.
Civil aviation, defence, and power generation are all benefiting from growing customer demand. Rolls-Royce’s business spans each of them and, thanks to the higher demand, it has seen revenues grow. I expect that to continue to be the case in coming years for both defence and power generation.
Civil aviation engine sales and servicing could also keep seeing growth, though in practice whether that happens depends on passenger demand. It has a tendency to fall dramatically from time to time, for example, because of a recession or an event that reduces people’s confidence to fly.
Valuation could be hard to justify
Rolls has set itself ambitious medium-term targets and so far has delivered well, hitting some of them ahead of schedule and setting higher ones.
So, the investment case as it stands is for a strongly performing business operating in sectors that are set to keep growing. Nonetheless, although I like that, Rolls-Royce shares now trade on what to me looks like an aggressive valuation.
The price-to-earnings ratio is 30. That is much higher than I would be comfortable paying for a mature company in a mature industry, which I think is a fair description of Rolls.
Here’s why I won’t be investing
One possible justification for that valuation is the potential for earnings growth. Given strong customer demand and the company’s aggressive plans, that seems likely. If it happens, it could push Rolls-Royce shares higher even from here.
But what if it does not happen?
That could be for internal reasons: Rolls is a complex company with extended project lead times that has long been inconsistent when it comes to financial performance.
External factors might throw a spanner in the works too. The pandemic and associated travel restrictions brought Rolls-Royce to its knees and the shares slumped to sell for pennies. Another unexpected sudden downturn in travel demand could come out of the blue at any time.
The valuation is too high for my comfort, so I will not be investing.
