After its mind-bendingly fabulous run, I thought the Rolls-Royce (LSE: RR) share price must surely run out of juice. I’ve even been toying with banking my profits and hunting for the next big FTSE 100 recovery story.
Now I’ve thrown my crystal ball away. The engineering giant is still on fire, climbing 10.65% in the last week alone. So now I’m sitting on an even bigger paper profit.
Rolls-Royce shares are now up 120% over the last year, and a scarcely believable 1,136% over three. I can barely get my head around that. So what’s driving the latest surge?
It hasn’t delivered any notable updates this year. We’re all waiting for full-year results, due on 26 February.
This FTSE 100 sector is surging
But a quick glance at the three best-performing FTSE 100 stocks over the past week offers a clue. Defence giant BAE Systems tops the table, up 18%, followed by Babcock International Group, another defence specialist, up 16.65%. Rolls-Royce is third.
Uncertainty over Venezuela, and US President Donald Trump’s call for a 50% increase in US defence spending to $1.5trn by 2027, has lit another rocket under the sector. If Rolls-Royce has lagged BAE Systems and Babcock, I can see two reasons.
First, it isn’t a pureplay defence stock. The bulk of its revenues still come from building and maintaining engines for civil jet planes. It also has a power systems division and a potentially huge opportunity in small modular reactors, or mini-nukes.
Second, the shares are very expensive. Last time I wrote about Rolls, I was uneasy about its price-to-earnings ratio of 57. Now it’s shot past 62.
BAE Systems is inevitably pricier after its one-week spike, but its P/E is ‘only’ 29.5. Babcock stands at 28.8. They’re not cheap, but nowhere near super-premium Rolls-Royce territory. On the other hand, the forward Rolls-Royce P/E for 2025 is just 21.5, which is a lot more reasonable.
A very expensive stock
As ever, new opportunities bring new risks. If the US doesn’t ramp up defence spending at the speed Trump demands, Rolls-Royce could retreat in disappointment. Any easing of geopolitical tensions would have the same effect, as would a slowdown in civilian air travel if the global economy falters.
Its power systems business looks exciting, with AI hyperscalers carpeting the plant with energy-hungry data centres. But if AI turns out to be a bubble, Rolls-Royce won’t be immune.
Mini-nukes also add a whole new layer of excitement, and risk. The technology has to work, regulators have to sign it off, and there are worries about nuclear waste. Once again, investors appear happy to shrug this off and chase the share price higher.
February’s results should give us a much clearer idea of how Rolls-Royce is really doing. Any earnings miss would be punished hard, given today’s heady valuation. But I’ve now given up on the idea of taking profits. I’ll just sit back and enjoy the ride. However, if I didn’t already own the shares, I wouldn’t buy them today. I think it’s too late to consider joining the party.
Investors watching the stock climb ever higher may have to swallow their disappointment and look elsewhere. I can see plenty of opportunities on the FTSE 100, although they’ll struggle to match this one’s extraordinary run.
