Another week, another all-time high share price for Rolls-Royce (LSE: RR). Rolls-Royce shares have been on an incredible tear, and are now a dizzying 945% higher than they were five years ago.
July 2020 was not even the weakest point for the Rolls-Royce share price, incidentally. An investment of £1,000 made at the October 2020 low is now worth over £24,000 – and earning close to a 16% dividend yield to boot!
That sort of performance is almost unheard of for a long-established FTSE 100 company in a mature industry.
At first glance, it may smell of a share waiting to crash back to earth. But, with Rolls-Royce shares continuing to demonstrate incredible momentum, could the price possibly be a bargain even now?
Three explanations for the rise
To answer that question, consider three different explanations for the soaring share price.
One is that the company has been wringing out efficiencies in what was essentially a solid business struggling amid difficult market conditions.
Such cost savings could boost profit margins. That would justify some of the performance of Rolls-Royce shares in recent years. But there are limits to squeezing costs. That explanation alone makes it hard to justify the current price-to-earnings (P/E) ratio of 32, let alone a higher one in my view.
Customer demand is growing
A second possible explanation is that the business is set to benefit from positive external forces.
Growing civil aviation demand in recent years is one. Another is soaring defence expenditure by western governments, while ongoing growth in power demand is also relevant here. All three of Rolls-Royce’s business divisions are in growth mode as a result.
Still, even if that leads to earnings growth, how much higher could it push the Rolls-Royce share price?
A P/E ratio of 32 looks high to me for a mature industrial company. Civil aviation demand is strong but risks falling sharply in the next economic downturn, or if there is an unexpected event such as a war or airborne terrorist attack.
So, even if Rolls is benefitting from a positive demand environment, I think its share price may currently be overvalued. That brings me onto the third possible explanation – that the company is undergoing a fundamental transformation that merits a higher valuation.
Rolls-Royce has been changing
There is some evidence to support such a viewpoint, from non-strategic asset sales in recent years to the aggressive target-setting of current management. The sort of growth ambition we have seen is a far cry from past decades at the aeronautical engineer.
If it can allocate capital more effectively over time, focus on highly profitable sectors, deliver on increasingly aggressive targets, and also ride demand trends both in aerospace and power systems, I think the Rolls-Royce of a decade from now could be a far better-performing business than the one that exists today.
That could drive earnings far higher – and make even the current Rolls-Royce share price seem like a bargain.
Still, I am not investing. Both the second and third scenarios above remain to be proven. The current share valuation, let alone a higher one, leaves no margin for error, in my view.
So, though I think Rolls-Royce could move even higher, the current risk-to-reward ratio does not match what I seek as an investor.
