Rolls-Royce (LSE:RR) shares are up more than 1,100% over the last five years. But even with the post-pandemic momentum having worn off, the firm is going from strength to strength.
The stock reacted positively last Thursday (26 February) to a strong update. So, is there still a chance for investors to consider buying the stock, or is it too late?
Still going strong
Rolls-Royce’s latest update reported strong results across all its divisions. The firm is benefitting from higher defence spending and back-up power requirements for data centres.
Neither of those is going away in the near future. But the real driving force behind the company has been – and continues to be – its commercial aerospace operation.
Better engine reliability has been a big help for the business. This should help bring down servicing costs, resulting in better profitability from those contracts.
Demand is also strong, with the number of flying hours well above pre-pandemic levels. In other words, the company has a lot of scope to keep providing investors with good news.
Is it worth it?
Is a 1,100% rally too much, or not enough? The answer comes down to how much cash Rolls-Royce is going to generate over the medium and long term – and especially in the next few years.
The firm’s guidance is for free cash flows to be between £3.6bn and £3.8bn in 2026. And it’s set to grow by at least 12% a year until 2028, which represents a very strong outlook.
Right now, though, the company has a market value of £111bn. So even £5.8bn in free cash flows only represents a 5.2% annual return – and that’s still a couple of years away.
Given this, I think investors need to ask themselves seriously whether the stock hasn’t got ahead of the underlying business. At the very least, it’s priced for some strong results.
Risks
Rolls-Royce’s business is protected by huge barriers to entry. But that doesn’t guarantee success and investors need short memories to forget that things don’t always go to plan.
The chances of a Covid-19-style pandemic being repeated are low, but a future recession at some point is almost inevitable. And that could really slow the nice trajectory the firm is on.
Exactly what could bring that on is unclear. But the weekend’s developments in Iran are a good reminder that things can happen quickly and big events often don’t provide notice.
The Rolls-Royce share price doesn’t look like an extreme overvaluation to me. Equally though, I don’t think it’s offering much in terms of protection from future issues.
Buying opportunities
I’m not convinced that right now is the time to buy Rolls-Royce shares. But I am convinced that a better opportunity is going to present itself in the future.
I think it’s not a question of if, but when. Being a good investor is about being in a position to buy stocks when short-term challenges make them unusually cheap.
That’s where Rolls-Royce was five years ago, but it isn’t where it is right now. Buying shares at today’s prices might turn out ok, but I’m looking at other opportunities for my portfolio.
