Rolls-Royce (LSE: RR.) shares are trouncing the FTSE 100 this year. Year to date, they’ve risen around 64% versus a gain of about 4% (not including dividends) for the UK’s blue-chip index.
Can the aerospace company’s shares continue to outperform the index? Let’s discuss.
New engine deals
One reason to be optimistic that its shares can continue to outperform is that the company’s winning new business now airline travel is picking up.
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In an update earlier this month, Rolls-Royce told investors it recently received its biggest ever order of Trent XWB-97 engines, with an Memorandum of Understanding (MoU) for 68 engines for Air India.
Further developments on this front could propel the share price higher.
Major cost reductions
Another reason to be bullish is that new CEO Tufan Erginbilgic, who took over as boss in January, is in cost-cutting mode. And the company appears to be making progress on this front.
“We are encouraged by the early progress of our commercial optimisation and working capital workstreams, with positive results expected to build as the year goes on”, management recently said.
Cost cutting has also led to big share price gains for some other companies too. Meta Platforms is a good example.
So if the company can execute well here, the share price could keep climbing.
Improved sentiment
A third reason to be optimistic is that broker sentiment is improving significantly.
When I covered Rolls-Royce shares in late December, only four out of the 18 brokers covering the stock rated it a ‘buy’ or ‘strong buy’. Today however, that figure has risen to nine.
Similarly, in December, four brokers had ‘sell’ ratings on the stock. Today, the figure is only two.
This is encouraging.
Meanwhile, broker’s share price targets are also rising. For example, last week, analysts at Jefferies raised their target price to 210p from 170p. Further price target upgrades could push the stock higher.
High valuation
One factor that could prevent the stock from outperforming the Footsie however, is the valuation. Right now, it looks pretty full.
Currently, analysts expect Rolls-Royce to generate earnings per share (EPS) of 4.99p for 2023 and 7.53p for 2024.
At today’s share price, these forecasts give price-to-earnings (P/E) ratios of 31 and 20 – well above the average FTSE 100 P/E ratio (about 14).
I don’t see a lot of room for multiple expansion at these levels.
So we need to see EPS jump for the Rolls-Royce share price to continue rising, to my mind.
Now, on one hand, the cost cuts I mentioned earlier could help boost EPS. However, on the other hand, supply chain issues could limit EPS growth.
In its recent update, management said supply chain management “remains a key operational challenge”, especially in Civil Aerospace.
My view
Given the relatively high valuation here, I wouldn’t be going all in on Rolls-Royce shares today. The shares could continue to outperform the market, but outperformance certainly isn’t guaranteed.
So I think it’s important to own other stocks for diversification.
