While Rolls-Royce Holdings (LSE: RR.) shares have been rocketing, analyst price targets have done so alongside. Has anyone been expecting expert enthusiasm to fade a bit as the valuation has grown?
Well, it mostly hasn’t. The top of the range of broker price targets currently stands at close to 1,750p. That’s around 50% ahead of the price at the time of writing. The low end of the scale, meanwhile, suggests we could see a fall of about 20%. So it seems not quite everyone is on board for the ride.
I just wonder how realistic the optimists are being. After all, Rolls-Royce shares are on a forward price-to-earnings (P/E) ratio of about 35 now. We need to look a bit more closely at that valuation.
Future potential
By FTSE 100 standards, that P/E might seem a bit steep. But compared to some of the big growth shares we’ve seen in the past, Rolls might still look like it’s in the bargain basement. In the short term, we often see big valuations based on modest current earnings. And they can fade rapidly as profits climb.
To look at an extreme example, Tesla in the US is on a P/E of 285. That, of course, is not driven by current earnings levels. And it’s really nothing to do with electric vehicles either. No, it’s based in what the potential for the business could turn into… and there’s little in the way of AI-led technology that’s off the table as far as CEO Elon Musk is concerned.
Now, UK investors clearly don’t expect Rolls-Royce profits to keep pace with anticipated Tesla-style growth. But anything significantly ahead of the Footsie market average could quickly make today’s valuation look sensible.
Next few years
Are forecasts for the next few years enough to make me want to buy? I’m really not so sure. Earnings predictions would drop the P/E to 25 by 2028, based on where Rolls-Royce shares are today. And yes, I’ve bought growth stocks at higher valuations than that in the past. Some of them even turned out well.
A look at the company’s anticipated cash generation makes me feel good. Analysts expect net cash of more than £5bn on the books by 2028. And this is a company that nearly collapsed under debt just a few years ago. I also love what CEO Tufan Erginbilgiç has achieved. How he’s reshaped the company has been truly remarkable.
Decision time?
Why do I hesitate over Rolls-Royce shares? It’s because I see a period of uncertainty ahead. How long can profit growth keep being driven by aero engines and defence demand? Those both surely must reach a plateau. So until we see how the next phase of transition for the company turns out, I’ll remain hands-off. And I think investors might be wise to consider some better-value alternatives.
I can, however, see why Rolls-Royce enthusiasts are still considering buying at today’s price. They might turn out to be right. Again.
