Image source: Rolls-Royce plc
The performance of Rolls-Royce (LSE: RR) the past few years have been incredible. Rolls-Royce’s share price, which is under 40p in 2020, is close to £6.
It has now bounced back a bit to trade around £5.50. But I think it could go up and pass the £6 mark. In fact, I wouldn’t be surprised to see it surpass £7 by 2025.
Momentum and basics
A few different factors affect pricing, depending on the situation.
One of them is the basic operation, which is below the business. I’ll talk about the Rolls’ which is basic in just a moment.
But pressure it may also be important.
As investors (and perhaps speculators) who are afraid of losing, they keep piling on the hot stock, pushing it higher. That can last for a long time but equally it can reverse suddenly.
Momentum ignores fundamentals on the way up – but the same can be true on the way down, too.
Even a strong business can see its share price fall in the short to medium term if enough investors don’t like it anymore (or simply choose to cash in their profits for other uses).
I like the look of the business, if things are going well
So, I think the momentum alone could push the shares to £6. That may be true up to £7, although that will be difficult.
But as a believer in long-term investment, not a trader, my interest is not in the track but in the fundamentals that should support the Rolls-Royce share price in the long run.
At £6, the price-to-earnings ratio would be around 22, and at £7, it would be over 25. That seems high to me.
However, that is based on the company’s current earnings. But imagine that Rolls could double its profits.
That may sound ambitious. But in the half-year period, basic earnings per share were 83% higher than in the same six months last year.
Not only that, but Rolls is still on track to meet its medium-term financial goals. If it can do that and earnings grow accordingly, I think £7 would be a reasonable valuation for the share.
I’m not ready to ride yet!
Despite that – a jump of around 27% from Rolls-Royce’s current price – I won’t buy.
Why not?
The target is ambitious and Rolls has a long history of mixed performance. Some of that is under the control of the company. But some important features are missing.
For example, demand for civil aviation engine sales (and, to a lesser extent, servicing) may decrease when people stop flying in droves, for example due to terrorist fears or pandemic-related travel restrictions.
I expect the shock of such demands and another time. They lie outside the control of the company. Perhaps its nuclear power and defense businesses will help absorb the shock, but civil aviation is the company’s backbone.
I don’t think the current share price, let alone higher, gives me enough of a margin of safety to properly reflect that risk.
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