Sometimes, Rolls-Royce (LSE: RR) seem as if it is on an unstoppable march.
Over the past week, the share price has nudged ever so slightly higher. Over one month, it is up 14% — and compared to a year ago, the gain is 69%. On a five-year timeframe, the Rolls-Royce share price gain has been an incredible 1,151%.
Past performance is not necessarily an indication of what to expect in future. Ultimately, no share is unstoppable.
Still, the upwards march of Rolls-Royce shares has not come out of nowhere. It reflects growing investor confidence in the long-term potential of the FTSE 100 industrialist.
Balancing risk and reward
A key part of investing is striking the right balance between risks and rewards.
Rolls’ ascent reflects shareholders’ hopes for growing rewards as the business performs strongly.
I see that as a reasonable expectation. After some very difficult years during the pandemic, when weak civil aviation demand brought the company to its knees, Rolls has been improving its business performance and also setting more ambitious medium-term performance goals.
Last year, for example, saw revenue grow 12% year on year. Statutory pre-tax profit more than tripled, to £2.2bn. The underlying profit before tax growth was less spectacular, but at 46% it was still substantial.
The business is performing strongly — and is still very ambitious
Rolls has been buying back shares by the bucketload and the annual dividend per share for last year was 9.5p.
That is great for a share that was selling for pennies as recently as 2022, although the soaring share price means that the current dividend yield is a rather uninspiring 0.7%.
So far, so good. But there could be more to come – potentially lots more. In the medium term, Rolls is aiming for annual underlying operating profit of £4.9bn-£5.2bn and free cash flow of £5.0bn-£5.3bn.
With demand high for civil aviation, defence, and power systems, as well as a strong brand and large installed base, I believe Rolls could well hit those targets – and may exceed them.
It’s the risks that concern me at this price
When it comes to the potential rewards side of the equation, then, I see a lot to like about Rolls-Royce shares. At the right price I would be happy to buy some for my portfolio.
But is the price right?
To decide that, I look not only at the potential rewards but also the risks – and I do not like what I see.
Civil aviation is an industry that can be blindsided by collapsing demand overnight due to unforeseen events outside its control. The pandemic demonstrated that – and the current war in the Middle East is only the latest in a long list of such events that can knock airlines sideways.
When that happens, airlines tend to be more cautious about ordering new aircraft. They also have less need to service engines that are seeing lower use than before.
That is a risk to both revenues and profits at Rolls, as servicing its large installed base of engines is a significant part of the firm’s business.
That risk concerns me because I think the current share price, at 46 times earnings, offers me zero margin of safety. On that basis, I have no plans to invest at the present.
