Image source: Rolls-Royce Holdings plc
The Rolls-Royce (LSE:RR.) share price has vastly outperformed over the last three years, climbing a jaw-dropping 1,250% since January 2023. Just to put this phenomenal gain into perspective, a £5,000 initial investment is now worth close to £67,500. And that’s before counting the extra gains from dividends paid along the way.
Can it keep going? And does it make sense for me to consider adding this UK stock to my portfolio today?
The bull case
Rolls-Royce’s stellar multi-year outperformance stems from a series of key milestones being hit under the leadership of Tufan Erginbilgiç.
Following a rather radical restructuring, the business quickly started thriving thanks to a post-pandemic travel demand resurgence, higher global defence spending, acceleration of its Power Systems segment driven by AI, and government validation for its small modular reactor (SMR) nuclear technology.
Today, many of these tailwinds continue.
Civil aerospace flying hours continue to climb, driving demand for the group’s aftermarket services. Meanwhile, global defence spending is still accelerating due to the ongoing war in Ukraine, tensions with China, and Middle East instability. And at the same time, tech giants continue to invest heavily in AI infrastructure and data centres, creating new growth opportunities for Rolls-Royce.
Combined, management expects to deliver over £3bn in its 2025 fiscal year. And with its SMRs steadily making progress towards commercial production, the long-term outlook for this engineering enterprise is quite exciting.
What could go wrong?
Even with the business delivering impressive financial and operational results, some potential early warning signs have started to emerge.
Economic weakness across the UK, Europe, and North America could intensify, particularly as the impact of tariffs and supply chain disruptions starts to creep in. If the situation devolves into a full-blown recession, demand for air travel could suffer, slowing or potentially even reversing the trajectory of large-engine flying hours.
This impact could be offset by higher defence spending. But should the geopolitical landscape start to stabilise or the fiscal landscape worsen, defence budgets could reach a limit.
As for Power Systems, strong AI investments are proving to be a handy tailwind for driving new orders. But if AI spending slows due to a shift in sentiment, this too could adversely impact Rolls-Royce’s momentum.
The bottom line
These potential headwinds may only result in a temporary slowdown for this business. However, investors aren’t likely to respond well should a slowdown emerge, considering the three-year share price rally has pushed Rolls-Royce’s forward price-to-earnings ratio to a staggering 40.6.
At this premium valuation, it seems the market’s pricing in a lot of the group’s expected future growth. But if cracks in momentum start to show, it could open the floodgates for volatility.
Therefore, while I admire Rolls-Royce as a business, its share price is just too high for my tastes. So instead, I’m looking at other growth opportunities in this sector. And luckily, there are plenty to choose from.
