Aircraft engineer Rolls-Royce (LSE: RR) has had an incredible stock market ride in the past few years. From a 2020 low below 40p, the Rolls-Royce share price today (20 March) hit over 10 times that level, crossing the £4 mark.
Its rise lately has been sensational. Can the shares keep gaining altitude and hit £5 next?
The displayed share-price chart uses ‘adjusted close price’.
Why the shares have jumped
When shares go up, there are typically two possible explanations.
One is what is known as fundamentals. A business is performing well, so investors deem it more valuable than before.
The other is known as momentum. As investors bid up the price of a share, that in itself generates more interest, leading to more price gains.
I would say the sharp increase in the Rolls-Royce share price – up 186% in the past year – is a combination of both fundamentals and momentum.
The business performance has been improving markedly. Last year saw revenues grow 22% and a pre-tax profit of £2.4bn compared to a £1.5bn pre-tax loss the prior year.
But I think the share price has also been driven by momentum. After all, even a year ago, the business was already looking set for recovery. Has it really almost tripled in value over the past 12 months?
The stock could keep rallying
Not everyone shares my view however. Based on fundamentals alone, there is a case to be made that the Rolls-Royce share price is justified – and may still be cheap.
Using the common valuation metric of price-to-earnings ratio, for example, the ratio here is 14. That does not look unreasonably high for a FTSE 100 firm with a sharply improving business.
Not only that, but things could get better from here. The company expects this year’s underlying operating profit to range £1.7bn-£2bn. That would be 7-26% higher than last year.
By 2027, the firm is targeting £2.5bn-£2.8bn, potentially a 76% jump from last year. If earnings were to rise at a broadly similar rate, the medium-term prospective P/E ratio based on today’s Rolls-Royce share price is in single figures.
If it seems to be making the right progress, I think the share price could rise higher and potentially top £5. In fact, if the company is on course to achieve those medium-term targets I think £5 could even be a bargain price.
Why I’m not buying
So why have I decided not to invest? Although I do believe the Rolls-Royce share price could yet go a lot higher, I think that depends on how well it performs against its ambitious financial targets.
That is not purely within Rolls’ control though. A pandemic, volcanic cloud, war, or even recession could see airlines suddenly cut spending overnight. It has happened quite a few times – and I see a risk it will happen again. Rolls can do little about that and civil aviation remains a large part of its business.
Even in such circumstances, defence spending might hold up. But civil aviation is core to Rolls’ business and I am not happy with the risk of a future sudden demand downturn.
This post was originally published on Motley Fool
