The Rolls-Royce (LSE:RR) share price is up 165% over 12 months. It’s the best performing stock on the FTSE 100 in that time. And since bottoming out in October 2022, shares in the British engineering giant are up 500%.
So, why do the shares keep gaining and could they really go further?
A monumental turnaround
When Rolls-Royce shares fell to 60p, there many were dissenting voices. It’s not like everyone thought the company was worth just £5bn. It was simply the culmination of two challenging, Covid-hit years, and the impact of Liz Truss’s disastrous premiership on investor confidence.
Improving investor sentiment, reflecting stronger economic conditions under Rishi Sunak, was complemented by a monumental turnaround from a business perspective. After selling off business units to pay down debts and cutting staff, the firm started to look much leaner.
And this, coupled with a stronger-than-expected recovery in revenue, is why we saw the company outpace earnings quarter after quarter.
Still beating expectations
There are few better signs for a company that continues to beat expectations. On 22 February, Rolls-Royce reported a more than doubling of its full-year profits. And this was driven by underlying operating profit in the civil aerospace business, which surged 497% to £850m.
All four quarters of the financial year 2024 saw Rolls-Royce beat expectations. In turn, management announced statutory earnings per share of 28.8p and underlying earnings of 13.8p. And for 2024, the company expects underlying operating profit of £1.7bn to £2bn and free cash flow of £1.7bn to £1.9bn.
Why it could continue to outperform?
Rolls-Royce is currently trading at 20.6 times earnings, but the company is expected to continue growing at pace in the coming years. In fact, earnings per share could grow at 33% per annum over the next three to five years.
As such, the forward price-to-earnings (P/E) ratio is lower than the current P/E ratio. And as the rate of expected growth is higher than the current P/E ratio, we end up with a price-to-earnings-to-growth (PEG) ratio under one.
In fact, Rolls’s PEG ratio of 0.62 suggests the company remains significantly undervalued to me.
The bottom line
Rolls-Royce operates three strong business segments; civil aviation, defence, and power systems. These are all sectors with high barriers to entry, and they’re also booming right now. Coupled with an attractive earnings forecast, I believe it’s a really strong investment proposition.
So, what are the risks? Well, despite surging 6x in 18 months, it’s worth pointing out that sentiment is still poor among UK investors. In other words, it may not be getting the attention it would if it were listed entirely in the US, and this could hold the stock back. Moreover, the pandemic highlighted the ease at which the civil aviation industry can be brought down. While I hope it never happens again, it did demonstrate a frailty of the Rolls-Royce business.
Nonetheless, I still believe the shares have huge potential, and they could still go higher.
