Image source: Rolls-Royce plc
This month has seen aeronautical engineer Rolls-Royce (LSE: RR) move in a now-familiar direction: up. The Rolls-Royce share price hit yet another all-time high.
That means it now stands an incredible 1,471% higher than it did just five years ago.
Overvalued – or undervalued?
That means that the Rolls-Royce share price-to-earnings (P/E) ratio now stands at 39.
To me, that looks expensive. After all, this is not some hot growth stock, but a mature company in a mature industry.
However, as the share price pushing ever higher in recent years has demonstrated, at least some investors reckon that Rolls is looking cheap, not expensive.
Could they be right?
Possibly. After all, the company has improved its financial performance notably in recent years. It has set and subsequently raised demanding targets.
If it continues to do well, earnings could grow. For this year, the firm now expects underlying operating profit of £3.1bn-£3.2bn, up from £2.5bn last year and £1.6bn the year before that.
Rolls is also benefitting from external factors, such as demand growth. Civil aviation demand remains buoyant. Defence spending is also in strong growth mode, while the company’s power systems division is riding a wave of demand that looks set to last for years.
The price may seem frothy — but is it?
Based on that, I think there is a potential justification for the Rolls-Royce share price to stand where it does.
In fact, if it continues to deliver on its goals and there are no nasty surprises along the way, I could imagine we may see the share move even higher.
Still, that incredible gain over the past five years and its current valuation does give me pause to think about whether the Rolls-Royce share price is frothy. The same might be asked of the wider market. Like Rolls, the FTSE 100 has set multiple record highs so far this year.
However, I do not see Rolls as necessarily being a useful barometer of what is going on with the wider market.
After all, its business really has undergone a transformation in performance over the past five years. It has a proven business and large profits.
I think a lot of the reasons for the dramatic turnaround in the Rolls-Royce share price are specific to its business and cannot necessarily be applied to the wider stock market.
I don’t mind missing out
Still, I have no plans to invest – and that suits me fine even if it means I end up missing out on further share price gains.
Why, given that I see a case for the share moving higher? In short: valuation.
Rolls has struggled at various points in the past because civil aviation demand has suddenly fallen off a cliff. Indeed, the five-year share price chart looks so compelling partly because five years ago, the civil aviation sector was struggling to deal with a demand collapse caused by the pandemic.
I see a risk of further such unexpected demand falls in future, perhaps eating badly into Rolls’ revenues and profitability. The current Rolls-Royce share price does not adequately reflect that risk, I feel.
