The Rolls-Royce (LSE: RR) share price has been in party mode, and what a swell party it was. The FTSE 100 aircraft engine maker’s stock is up a staggering 1,488% in the last three years, turning a £10,000 investment into a scarcely believable £158,800.
An investor who’d rocked up early could be sitting on a life-changing sum. Which only shows the power of investing in individual stocks, rather than collective funds or index trackers. There are risks, but huge potential rewards.
The problem with parties is they don’t last forever. At some point, the punchbowl runs dry, the band packs up and the fun stops. Nobody wants to show up at that point. With Rolls-Royce, there are signs the fun might be slowing. While the share price has climbed 106% in the last year, but there are reasons why it could struggle from here.
Stock valuation pressures
The party was still in full swing on 31 July, when Rolls-Royce published its first-half results. Operating profit jumping a meaty 50% to £1.73bn, while operating margins climbed from 14% to 19.1%. The company now expects a full-year operating profit of £3.1bn-3.2bn, up from £2.7bn-2.9bn.
However, its success has driven the stock’s valuation to the stars. Rolls-Royce now trades on a price-to-earnings ratio of almost 55, well above the FTSE 100 average of around 15. Investors are expecting near-perfect execution from the company, and at these lofty heights, even a minor slip can be punished.
Signs of caution are emerging. The shares have fallen 3% in the last month. That’s a modest slip compared to the stellar gains, but it does mean that latecomers will be finding themselves in a situation not seen for four or five years – making a paper loss on Rolls-Royce shares.
This may reflect a dip in defence stocks following their recent strong run (Rolls-Royce has a defence division too). Some may be worried about a potential US recession, and the fragile economy, which could hit demand for flights. Rolls-Royce earns big money from its aircraft engine maintenance contracts, which are based on miles flown. Supply chain snarl-ups and tariffs pose challenges.
Uncertain growth outlook
Investors will have to wait for the next trading date, due on 13 November, to see if Rolls-Royce can beat expectations yet again. Even if they do, the stock’s growth potential may be limited given today’s valuation, while bad news could be punished hard.
Investors might still consider buying, but only if they’re prepared to leave their money in for five to 10 years to give the company a chance to build on recent progress. I’ll hold what I’ve got but would only top up my stake on a dip.
Opportunities elsewhere
There are still believers out there. Consensus analyst forecast suggested shares could hit 1,233p over the next year, which would mark an increase of around 8.9% from today, if correct. I’m still cautious though.
There are plenty more potential recovery stories in the FTSE 100 and FTSE 250. Some may well be at the same stage Rolls-Royce was a few years ago. I’ll be targeting the next big growth story, rather than chasing the last one. They’re out there.
