Image source: Rolls-Royce plc
Rolls-Royce (LSE:RR) shares don’t exactly look cheap these days. The stock’s been the FTSE 100’s leading light, but a good amount of this has been driven by valuation multiples increasing.
So far though, this hasn’t really slowed the share price – it’s still up 110% in the last 12 months. So the big question is, why should anyone care if the stock looks expensive?
Looks expensive…
Officially, Rolls-Royce shares trade at a price-to-earnings (P/E) ratio of around 18, which isn’t particularly high. But this is probably the wrong number for investors to use going forward.
During the first half of 2025, the firm reported £4.4bn in net income. But around £2.8bn was from one-off boosts to earnings that aren’t likely to be repeated in future years.
Adjusting for this, underlying profits were £1.6bn – 64% lower than the official report. And that means comparing the firm’s market value with its earnings makes the stock look cheaper than it is.
On this basis, the P/E ratio is closer to 42, which is very high. But the stock was trading at this level a year ago and the share price has doubled, so why should investors start worrying about it now?
…So what?
Obviously, there’s no rule saying that just because the stock trades at a high multiple it has to come down any time soon. But investors looking from a long-term perspective need to think carefully.
A P/E ratio of 42 means the company’s going to have to grow a lot to be able to justify its current share price. As a result, smaller risks take on a larger significance.
Investors don’t need long memories to know what can happen to the firm’s cash flows when demand for air travel falters. And there are some real signs of weakness in US consumer spending.
If earnings growth slows, the multiple the stock trades at could fall, causing the share price to crash. But the bigger issue for investors is that the business might just not make enough money over time.
What should investors do?
Rolls-Royce has some interesting opportunities in defence and nuclear divisions. But its largest business is still civil aviation, which makes aircraft engines.
At the moment, the company’s largely focused on wide-body aircraft. These are primarily used in long-haul flights and this should give it some protection from downturns in consumer spending.
In the US, spending’s still strong among the highest-income householders – the ones more likely to make longer trips. But the firm has announced plans to get back into narrow-body aircraft.
This clearly provides opportunities to access a wider market, but it does increase the risk of earnings falling away in a recession. And that makes me a bit wary around the stock at the moment.
Risks and rewards
There are risks with Rolls-Royce shares, but this is true of every stock. What investors need to do is weigh these against the potential rewards.
Increases in defence spending and a potential transition to nuclear power are clear avenues for future growth. But I think the high P/E multiple makes this risky.
At today’s prices, a lot has to go right for Rolls-Royce shares to work out from an investment perspective. And I think there are more attractive opportunities to consider elsewhere right now.
