Over the past year, Rolls-Royce (LSE: RR) has seen its shares soar. In fact, the Rolls-Royce share price has gone up by 56% in that period.
Has the business improved enough to justify such a rise? Or might the shares have got ahead of themselves?
Improving business prospects
I definitely think the outlook for the business now is stronger than it was 12 months ago.
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The main challenge in recent years has been the reduced demand for civil aviation caused by pandemic-era government restrictions. Those have been progressively lifted and now even holdout markets like China are open to international tourism once more.
With appetite for civil aviation growing, the average number of hours each Rolls-Royce engine is used is set to increase. That should boost revenues and profits for the engineer. The travel boom could also see airlines order new aircraft, boosting engine sales.
On top of that, the defence industry is seeing increased demand, notably in Europe. That should boost revenues at Rolls-Royce’s defence business.
Rising demand could help the firm’s revenues. But its profitability also looks set to grow, as a new chief executive focuses on efficiency and implements another cost-cutting programme on top of the one launched several years ago.
Assessing the Rolls-Royce share price
But while business prospects have improved, is the change big enough to justify a 56% increase in the share price over one year?
I think the shares were beaten down more than they deserved a year ago, in fairness, so arguably some of that increase is simply moving closer to fair value. But even allowing for that, the shares have moved a long way. After all, although the company’s prospects look decent, it did make a £1.2bn loss last year. Some of that reflects weak exchange rates, but that risk will exist in the future too.
In fact, in four of the past five years, the business has made a loss north of a billion pounds. It was only profitable after tax in one of those years.
Last year it earned £121m. Its current market capitalisation of £12.1bn is a hundred times that much – and the company has net debt of £3.3bn to boot. That is 36% lower than the prior year but is still substantial.
Proving the potential
Despite falling 9% in the past fortnight, I am not convinced the Rolls-Royce share price has peaked. If the business lives up to its potential in coming months and years, I think we could see the shares trade at a higher level than they do currently.
My concern is that a lot of optimism is already baked into the share price. I think it is now time for Rolls to show that it can deliver on that potential despite its weak track record in recent years. That could be a long-term process and for now I see no immediate trigger to push the shares sharply higher. The company faces risks such as inflation hurting profit margins and the cost-cutting programme damaging worker productvity.
I have taken advantage of the Rolls-Royce share price surge to sell my holding. I am now waiting to see whether the business starts to grow into its current valuation before deciding whether to buy the shares again at some point in future.
