Last week – as has happened quite often in the past few months – Rolls-Royce (LSE: RR) hit another new all-time high. The trajectory of the Rolls-Royce share price over the past several years has been simply spectacular. The share has soared 951% over the past five years.
That has made a lot of investors very happy. The question for me is, am I too late to join them?
A business that can keep flying
Normally, if I hear of a large business that has seen its share price grow by anything like that amount, I wonder whether the share price has got carried away with itself.
When it comes to the Rolls-Royce share price however, I do think a case can be made for why it has risen so much.
During the pandemic, the company was on its knees. Civil aviation flying hours had slumped and with it Rolls’ order book, not just for engine sales but also in the lucrative servicing market.
Since then, aviation demand has come back in a big way. Defence spending has also grown in a way few people would have expected even just a few years ago.
Meanwhile, a change of management at the storied aeronautical engineer has seen it extend an aggressive cost-cutting programme as well as setting ambitious medium-term targets. It even met some of those ahead of schedule and so set more ambitious goals. That has been music to the City’s ears.
Valuation’s high but not crazy
Still, while the business has improved markedly, that soaring share price means that Rolls-Royce shares now trade for 32 times earnings.
I do not see that as cheap. In fact, it is too expensive for my tastes. I do not think it would offer me sufficient margin of safety for another unexpected event like a pandemic or terrorist campaign suddenly wiping out air travel demand again. So at the current price, I will not be investing.
Different investors strike their own balance between risks and potential rewards however. I can see why a price-to-earnings (P/E) ratio of 32 might look reasonable.
After all, Rolls’ efficiency programme combined with strong end markets ought to push up earnings per share significantly in coming years. On that basis alone, the prospective P/E ratio could be well under 32.
Things could get better
That alone could help the Rolls-Royce share price. The more management delivers on its promises, the more willing I think investors will be to assign a premium when valuing Rolls-Royce’s shares.
I also think that the FTSE 100 firm will likely benefit from significantly higher customer spending in all three of its divisions in coming years. Airlines have been buying lots of new planes over the past year, defence spending has soared and power generation is also an industry seeing ongoing growth.
So do I think today’s Rolls-Royce share price is a bargain? No. However, do I think it could move up even from its current levels in years to come? Yes, I do.
But the risks sit uncomfortably with me at the current valuation, so I will not be investing.
