Brilliant shares like Amazon and Nvidia have frequently hit all-time highs at expensive-seeming valuations – only to go on and soar far, far higher. That came to mind this month when Rolls-Royce (LSE: RR) hit a new all-time high.
On one hand, Rolls-Royce shares look expensive to me, trading for 29 times earnings. But could they still be a potential bargain for my portfolio from a long-term perspective? Consider how Amazon and Nvidia have performed in the past decade, soaring 905% and 25,387% respectively!
I do see potential for Rolls-Royce shares to move somewhat higher even from here but do not regard them as a potential bargain of that nature. There is one simple reason behind my rationale.
Here’s how businesses – and shares – usually grow
Why do I think Rolls-Royce shares are unlikely to match such stellar performances? Amazon and Nvidia both have scaleable business models. Once they invest in setting up the basic infrastructure, whether it is running an online store or designing a chip, the marginal cost of each transaction is limited. So building sales beyond a certain point has an exponential effect on profitability – and the share price.
I do not see Rolls-Royce as having such a scaleable model. Sure, once an aircraft engine or power reactor is designed, it can be built thousands of times. But the marginal cost of that, from parts to labour, is still high. I do not see Rolls-Royce getting the same benefits of scaleability as some businesses do.
For Rolls-Royce shares to grow exponentially then, most likely either sales revenues need to explode or profit margins must soar.
Mature business in industries with modest growth prospects
There, an obvious challenge emerges. Only so many new (civilian or military) aircraft engines are needed each year – and Rolls-Royce is already a leading player in the market.
So while there are drivers for sales growth such as expanded international travel or higher defence spending, over the long run I do not see those as stepchanges that will make the market exponentially bigger.
As for profitability, this has been a focus for Rolls-Royce in recent years and it continues to work towards ambitious, medium-term targets. Here too, there are limits. If profit margins get too high, many customers will simply ask for lower selling prices. Rolls can walk away from such deals – but at the risk of lost sales.
The business model of developing, manufacturing and selling complex specialist engineering products is labour-intensive, expensive and not easily scaleable for the most part. That means it is different to, say, Amazon’s core business model.
Room for share price growth
Still, Rolls-Royce shares might keep moving up. Investor momentum remains strong, as shown by this month’s all-time high. The company’s commercial performance is underlining the investment case. Both civil aviation and defence spending have climbed markedly in recent years.
To me though, the share price already looks too high. A weak economy could hurt civil aviation demand, which a sudden unexpected downturn due to an event such as a war or a pandemic could upend the company’s economics overnight as it has in the past. I do not think the current price properly reflects such risks. I will not be investing.
