It’s been an encouraging 2026 so far for Rolls-Royce (LSE:RR) shares. We’re only a week in and they’re up 8.5% already!
This means any brave soul who invested 10 grand in the FTSE 100 stock a week ago would now have £10,850 (or thereabouts).
Of course, anyone who invested in the engine maker at the start of any year in recent times would now be sitting on market-thrashing gains. The stock’s up more than 1,000% in five years and over 3,000% since the Covid lows!
| Year | Annual return |
|---|---|
| 2023 | 221.6% |
| 2024 | 89.7% |
| 2025 | 95.4% |
| 2026* | 8.5% |
Why is the stock rising?
The reason for the sudden jump in the share price is almost certainly related to Venezuela. The capture of president Nicolás Maduro and his wife by US special forces triggered a massive sudden rotation into defence stocks.
Rolls-Royce often trades up and down with these because it has a defence division, accounting for approximately 25% of group revenue. It builds nuclear reactors that power attack submarines, as well as engines for military aircraft and armoured vehicles.
Year to date, the only two FTSE 100 stocks that have done better than Rolls-Royce are Babcock International (+15.5%) and BAE Systems (+12.4%). Both are defence shares.
Defence budgets marching higher
Elsewhere, the US has seized a Russia-flagged vessel in the North Atlantic linked to sanctioned Venezuelan oil. And the US wants Greenland. Such sudden events strongly point to elevated global military budgets, both in Europe and the US.
In theory, this bodes well for Rolls-Royce’s defence unit moving forward. However, President Trump has also vowed to block US defence firms from paying dividends, which I expect will cause significant volatility across the sector.
The latest US intervention in Latin America would likely reinforce a higher baseline for defence spending, particularly around aerospace, surveillance, missile systems and logistics.
Zacks Investment Research.
Beware the valuation
I first bought shares of BAE Systems in late 2022, then Rolls-Royce in mid-2023. I’ve added to both twice since. As such, I already have decent exposure to the defence sector, which I admit isn’t for everyone (some understandably have ethical objections).
That said, there’s more to Rolls-Royce than military spending. Its largest division is civil aerospace, with its engines powering the Airbus A350 and other long-haul aircraft. It’s also benefitting from the AI data centre buildout too, with strong demand for its back-up power systems.
So, there are multiple avenues of growth open to the company in future. Despite this, I was a little bit wary of the stock’s valuation at the start of the year, and even more so now after the latest jolt higher.
That’s because the forward price-to-earnings ratio is now above 38, based on next year’s earnings forecast. And the 12-month share price target among analysts is 1,258p — almost exactly where Rolls-Royce is trading right now.
None of this means the stock won’t head higher, of course. Some analysts might up their targets, while Rolls-Royce could exceed market expectations in its forthcoming financial results.
On balance though, the stock looks a bit pricey to me now. I’m not expecting another barnstorming year (though as a shareholder I hope I’m wrong!).
The current valuation leaves little room for error if results come in even slightly below expectations. As such, I think there are more attractive buying opportunities elsewhere in the FTSE 100 right now.
