After its performance in the past year, Rolls-Royce (LSE:RR) certainly has momentum in the stock market right now. Over the past year, the Rolls-Royce share price has soared by 150% and is now around £3.71.
If it keeps going, at some point it might hit £5.
Then again, what if things go badly?
Rolls-Royce was selling for pennies as recently as 2022. In 2020, the share price was well below 50p. Could it head back there?
Positive momentum and strong business progress
The surging Rolls-Royce share price has benefitted from its own momentum to some extent. Investors have warmed to the turnaround story and the dramatic share price action.
But behind the stock market performance lies a turnaround in the business performance at the engineering firm. After the hard pandemic years when demand from civil aviation customers slumped, it has come storming back.
Last year’s results show that things have been going well. Revenues grew 22%, free cash flow more than doubled and a £1.5bn pre-tax loss was turned into a £2.4bn pre-tax profit.
The business thinks there is more to come. Its medium-term targets foresee sharply stronger performance than last year.
Share price direction
I think there is already a lot of expectation reflected in the current share price.
Yes, the results were strong and, yes, they could get even better from here. If they do, I would not be surprised to see a £5 price at some point in the next few years.
That would be an uplift of just over a third from the current level. That could be justified by ongoing improvements in business performance of the sort we saw last year.
A £5 share price would reflect a price-to-earnings (P/E) ratio of around 36. That seems high to me, though such a P/E ratio is currently commanded by fellow FTSE 100 engineer Spirax.
But Rolls expects underlying operating profit to grow as much as 57% by 2027 from last year’s levels. If earnings also grew at that rate, a £5 share price would equate to a P/E ratio of 23. I think that is within the realms of the possible.
Some risks – and my approach
But could things go the other way?
Rolls has a lot going for it. It operates in a market with high barriers to entry, few competitors, and big price tags. Demand could well grow both in civil aviation and defence, as well as in power systems where the company last week noted “strong demand for power generation solutions and services in the rapidly expanding data centre market”.
But when it comes to selling and servicing aircraft engines, the outlook often looks good – until it does not. That was true at the start of 2020. It was also true in summer 2001.
If an event outside Rolls’ control suddenly, unexpectedly puts the brake on airline spending, its revenues and earnings could collapse. Even with a leaner cost base than in 2020, that would be bad news and could send the shares spiralling downwards.
For the Rolls-Royce share price to hit 50p again I think there would need to be a large, sustained demand shock. That is a risk, though. I have no plans to invest.
This post was originally published on Motley Fool
