Let us be clear, today is an awful day for the the stock markets. Russia has declared war on Ukraine, sending global markets reeling into the red. Some stocks, like the FTSE 100 aero-engine producer Rolls-Royce (LSE: RR), however, have been impacted more than others. As I write, it is trading almost 15% below yesterday’s close, a decline only smaller than those of the two FTSE 100 Russian companies, Polymetal International and Evraz.
Roll-Royce swings back into profits, but valuations are high
So why has the Rolls-Royce share price reacted this badly? I can think of plenty of reasons, including its latest results, released earlier today. They are not bad, to be sure. In fact, the company has just swung back into full-year profits after not one, or two, but three whole years of reporting losses. Ideally, this should be huge positive. But here is the catch. The profits are quite small at £124m. This translates into a price-to-earnings (P/E) ratio of 80 times! This is a huge market valuation, by any standards. The FTSE 100 index has a P/E of around 16 times, for example.
I could still go with it, if the company was optimistic about its future. That could imply far bigger profits in the future, and by extension a far more reasonable forward P/E at today’s prices. To be fair, Rolls-Royce isn’t exactly pessimistic. But it is not terribly upbeat either. I mean, it expects its operating profit margin to remain broadly unchanged. And this is the only reference in its guidance to its future profits.
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Civil aerospace is vulnerable to macroeconomic fluctuations
Moreover, its biggest source of revenue is its civil aerospace division, which posted an underlying loss in 2021 for obvious reasons. Airlines were impacted throughout 2021 because of the pandemic, and that reduced demand for both aero-engines and their servicing. It is probably because of this that over the past year, Rolls-Royce’s share price has fluctuated but is essentially unchanged. I am not sure if it will be completely out of the woods in 2022 either. All restrictions have been removed but another variant could come along and spoil the party.
Also, oil has touched $100 per barrel, a risk I had highlighted in context of the stock earlier. there is a good chance that some of the increased flying costs could be passed on to consumers. This in turn could impact demand. Moreover, rising oil prices are bad news for inflation, which is already super-elevated. Runaway inflation poses the risk of derailing the ongoing economic recovery. And if that happens, travel would be one of the impacted sectors.
What I’d do about the Rolls-Royce share price
Yet, there are silver linings to the stock. Its defence segment is doing quite well. It is the biggest contributor to the company’s earnings. And Rolls-Royce is positive about is prospects for 2022 as well. It could soon overtake civil aerospace as the mainstay for the company, which in turn could make the company less vulnerable to fluctuations in the macroeconomy. For now though, the stock remains a risky buy for me. I am only just watching it for now to see how things develop.
