Over the past year, shares in Rolls-Royce (LSE: RR) have tripled. That is some achievement. The Rolls-Royce share price was the best performing among FTSE 100 stocks last year.
This year has continued well, with the shares leaping by over half, so far.
The shares hit a new 12-month high this week and have been edging closer to £5, reaching £4.72 at one point. If they get to £5, could they keep going and hit £6?
Strong business performance
When a share triples in a year, one of two things typically happen (or both at once). Either the business prospects look much better than before, or investors are buying in with a spirit of hope rather than pure financial judgment.
It could be that a share price that was previously undervaluing the company is snapping back into shape. But to do that by tripling is rare.
In the case of the Rolls-Royce share price, what is going on? Certainly, the business has been improving its performance. Last year saw revenues jump 22%. A £1.5bn statutory loss the prior year turned into a £2.5bn profit. Underlying free cash flows more than doubled, to £1.3bn.
As well as an improved performance, the outlook for the company is stronger than a year ago.
In that period, the aeronautical engineer has unveiled a challenging set of medium-term targets. For example, it expects free cash flow to hit £2.8bn-£3.1bn by 2027.
Is the share price getting frothy?
Still, while the business is powering ahead, does that merit the sort of jump we have seen so far in the Rolls-Royce share price, let alone pushing it to £6?
I think the answer may be yes. A share price tripling in a year may sound frothy. But valuing the company on the basis of its 2027 targets, a £6 share price seems reasonable to me.
That would imply a market capitalisation of just over £50bn. That would also suggest a price-to-earnings (P/E) ratio (based on underlying operating profit, not statutory earnings) of 16-20. The price would represent 16-18 times free cash flows.
Those ratios are a bit high for my comfort, but they could be justified. Indeed, Rolls’ US rivals RTX and GE Aerospace trade on a P/E ratio (based on net income) of 20 and 38 respectively.
The targets are only medium term. If the company builts investor confidence by achieving them (between now and 2027) and then sets higher long-term goals, the share price would merit a premium, in my opinion.
So £6 looks achievable to me, from a long-term investing perspective.
Lots to prove
But I am not investing at the current share price, for two key reasons. First, those targets are just targets. Progress is strong but there is a lot still to prove.
After the share price gain, I think the City will be unforgiving if Rolls-Royce does not deliver on what it has set out. It has a long history of inconsistent performance under various managements. I see that as an ongoing risk.
Secondly, a sudden dip in demand outside Rolls’ control could upset the apple cart almost overnight, as it did with the pandemic and 2001 terrorist attacks. I do not think the current price adequately reflects that risk.
This post was originally published on Motley Fool
