It has been an incredible few years for Rolls-Royce (LSE: RR). The aeronautical engineer was on its knees a few years ago, with a share price in pennies. But Rolls-Royce shares have staged a stunning recovery, moving up 989% in the past five years.
Lately, though, there has been a price correction. The Rolls-Royce share price has tumbled 15% in just a few weeks. Despite that, the company still sells for 40 times earnings and has a market capitalisation of £96bn.
So, could things get worse from here?
Problems on multiple fronts
As I see it, recent geopolitical developments have opened up several potential problems for the FTSE 100 firm.
The most obvious one is what high oil prices and war might mean for the civil aviation industry. Usually they lead to fewer people wanting to fly and squeezed profit margins for airlines.
I think that could well be the case again now, curbing carriers’ enthusiasm or ability to spend large sums on non-essential engine maintenance or new aircraft orders.
That could end up being a big hit to Rolls’ revenues in the next several years.
But it is not the only risk the Middle East war has thrown up for the company. High inflation can hurt the company’s profitability, as it pushes up prices for everything from metal supplies to energy. Given its heavy manufacturing operations, that is a notable risk for Rolls.
For now, no obvious signs of change
Still, while the wider market apparently perceives this risk — hence the share price fall — for now the company has not signalled any specific concerns about what the war means for its financial performance.
In recent years, it has demonstrated that it is well able to keep a tight lid on costs. That financial discipline could help it as it navigates the current environment.
Meanwhile, it is also worth remembering that while civil aviation is Rolls’ biggest business division, it is far from the only one. The defence business has seen demand grow strongly in recent years and that looks set to continue. Meanwhile, energy security questions will likely also help boost interest in Rolls’ power business.
With proprietary technology, a large installed user base, and talented engineers, I see a lot to like about Rolls-Royce’s business.
The share looks overvalued to me
Still, after a stunning few years of share performance, I think the recent correction makes sense from a valuation perspective.
In fact, the share price would need to fall further for it to be what I see as an attractive valuation. The price-to-earnings ratio of 40 I mentioned above still looks unjustifiably high for my tastes, given the risks the company faces.
Markets are not always rational and it could be that the recent price fall turns out to be a blip. Or, Rolls might manage to keep improving its business performance as it has in recent years, potentially justifying a higher share price.
However, I reckon the glory days of recent years for Rolls-Royce shares could be over, with the company needing to prove it can justify such a heady price tag.
For now, it still looks too high to me, so I will not be buying.
