It has been a simply stunning few years for investors in Rolls-Royce (LSE: RR). The Rolls-Royce share price has moved up by 1,215% over the past five years.
For a large company in a mature industry, that sort of stock market performance is exceptional.
Last month, the Rolls-Royce share price hit an all-time high. Since then, though, it has been moving downhill.
It has fallen 6% in the past month and now stands 8% below that all-time high it hit just weeks ago.
That might not sound like a big fall. Perhaps, after all, the share is just taking a breather before its next leg up?
But what if this is not just a breather and Rolls has started a longert-erm process of giving up some of its strong gains from recent years?
Valuation concerns – or not?
Given the sort of growth we have witnessed in the share price over recent years, a valid concern is whether Rolls-Royce has simply become overvalued. Does it really merit a market capitalisation of £93bn?
I think it may. In fact, the aeronautical engineer might even merit a higher valuation.
Its current price-to-earnings (P/E) ratio of 16 does not look unreasonable to me, given the company’s improved financial performance, proven business model and robust end markets. It is markedly lower than the FTSE 100’s overall P/E ratio of 20.
With civil aviation demand still strong and European governments continuing to spend more on defence, I see scope for Rolls to grow its earnings over coming years. That could help it justify a higher valuation.
Some investors may be taking profits
Still, that is not a given.
We have seen repeatedly in the past that sudden, unforeseen events can make civil aviation demand plummet. From pandemics to geopolitical tensions, I see that as being as much of a risk as ever.
Personally, I do not think that risk is properly reflected in the current Rolls-Royce share price, which is why I have no plans to invest.
Meanwhile, as the global economy continues to look uncertain and civil aviation demand is showing growing signs of weakness in some markets, I reckon some investors may be deciding to take their Rolls-Royce profits off the table by selling the shares.
If such a pattern picks up pace, it could mean the share falls further even though the business performance remains solid.
There could be more upside
Only time will tell whether City enthusiasm for Rolls is waning, or will stay strong.
Over the past few years, the company’s management has shown it can excite investors by setting ambitious goals and consistently delivering on them. Investors love that.
The business looks In good health. If things continue to do well, I reckon the recent drift down could be reversed — and the share may start to move up again.
But if investor sentiment is changing, that may not happen.
Given that the current valuation does not look excessive, I do not expect the shares to move a long way south from here without some trigger like an earnings miss or wider stock market turbulence. Still, that risk does sit well with me at the current share price.
