In 2022, when a certain Elizabeth Truss was drawing unfavourable comparisons with a wilting head of lettuce, Rolls-Royce shares sank to near a 20-year low. What happened next was breathtaking.
The stock started surging. A combination of new leadership, higher defence spending, and flights resuming post-pandemic brought about a spectacular turnaround. A £62,500 stake invested at that low point would now be worth £1m and change.
Turning that much cash into a million so quickly is rare, but it won’t come as that much of a surprise to anyone who’s spent a few years watching stock markets. These things happen, and they happen more so amidst the doom and gloom. Get greedy when others are fearful, as Warren Buffett is famous for saying.
The question now is what comes after. Is Rolls-Royce overvalued now? Should it be avoided at all costs? Or is there scope for the stock to continue surging in the years and decades to come? Spoiler alert: I think it can.
All cylinders
The beauty of Rolls-Royce is that it’s a company firing on all cylinders, a fitting metaphor for a company that makes engines.
The engines it makes for the defence industry powers some of the most advanced fighter jets to ever exist. As countries worldwide ramp up defence spending, it increases demand for such products.
The engines it makes for civil use are in demand by airlines across the world, too. The main drawback here is that Rolls-Royce is focused on wide-body aeroplanes rather than narrow-body, which are becoming more popular. A problem? Perhaps not, as Rolls is looking to expand its product line in that direction too.
Its engineering capabilites doesn’t just stop at aeroplanes either. The small modular reactors (SMRs) it is developing are like mini nuclear power stations and could be a huge growth avenue if and when they get the technology right.
Alarm bells
What is there to be cautious of here? One metric that might set alarm bells ringing is the valuation. Rolls-Royce trades at 53 times forward earnings. That makes the stock pricier even than artificial intelligence titan (and world’s largest company) Nvidia.
Can Rolls-Royce justify such a valuation? Earnings would need to roughly triple for it to come close to the FTSE 100 average. That’s a lot of growth for what is already the fifth-largest company on the London Stock Exchange.
On the other hand, many of the best growth stocks tend to come with a premium on the shares. Not to mention that, with such bright prospects, Rolls-Royce could retain an elevated valuation long into the future too.
On balance, I do think this is one of the UK’s brightest stocks and one investors may wish to consider adding to a diversified portfolio.
