If I’d invested in Rolls-Royce (LSE: RR.) a year ago, I’d be a very happy man today. Its share price is up 211% in that time. By comparison, the FTSE 100‘s up 7.4%.
After its tremendous run in 2023, I didn’t expect Rolls to keep up the pace. But instead of hitting the brakes, the stock’s continued to climb. It’s up 57.4% so far in 2024.
But that begs one question. Is the Rolls share price overvalued at £4.69? Let’s explore.
Valuation
I’m going to use the price-to-earnings (P/E) ratio to help me answer that. It’s one of the most common valuation metrics out there.
As seen below, Rolls currently trades on a P/E of 16.3. That’s above the Footsie average of 11 and based on that, Rolls looks expensive. That said, it’s considerably cheaper than its Footsie peer BAE Systems, which trades on 22.9 times earnings.
Created with TradingView
But what about looking forward? Investors are more concerned about where a stock has the potential to go as opposed to where it’s been. Therefore, let’s look at its forward P/E.
As the chart below shows, Rolls looks expensive. It trades on a forward P/E of just above 31. BAE Systems trades on 17.8 times forward earnings. The average Footsie forward P/E is again around 11. Based on that, Rolls looks like its share price could be overvalued.
Created with TradingView
My concerns
That’s my largest concern with the stock. I’m content with paying a small premium for Rolls, given the quality of the business. Even so, I’m fearful investors have pushed the stock up too high too soon.
While in the short-term, market sentiment can dictate a stock’s price, in the long run, its fundamentals that are the real growth drivers.
Just keep rising
Then again, Rolls could just keep rising. There’s plenty to suggest that could happen. For example, its latest trading update showed the firm continues to gain momentum. In the first four months of the year, large engine flying hours returned to pre-pandemic levels.
It’s also strengthened its balance sheet in recent times. As such, over the last few months, Fitch, S&P, and Moody’s have all upgraded their credit rating for the company. That said, it’s worth noting it still has a net debt of nearly £2bn.
The business is targeting between £2.5bn and £2.8bn in operating profit and between £2.8bn and £3.1bn of free cash flow in the medium term. There’s no doubt those are ambitious aims. But if the firm manages to meet them, then that could see the stock soar in the coming years.
My move
That said, Rolls is a stock I plan to keep on my watchlist for the time being. I’m cautious that any sign of a slowdown in growth could see its share price tumble. I’m worried some investors may have got carried away.
If we see its share price pull back, that’s when I’ll strongly consider making a move. Until then, I’ll be holding off. It’s set to release its half-year results for 2024 in August, so I’ll be keeping a close eye.
This post was originally published on Motley Fool
