It been a satisfying year for shareholders in Rolls-Royce (LSE: RR). Over the past 12 months, Rolls-Royce shares have increased in value by 180%.
Yesterday (10 May) they hit their highest point ever (allowing for changes in the share structure over the past few years).
When a share performs as strongly as that, it could be that it is overvalued and so headed for a fall. On the other hand, the momentum that has driven the shares this far could push them higher.
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Despite their meteoric rise, I think it is possible (though not necessarily likely) that Rolls-Royce shares could still double from here.
The current valuation does not look far-fetched
A helpful starting point is to look at whether the shares currently look overvalued.
I do not think they are.
The price-to-earnings (P/E) ratio is 15. That is not exactly a bargain. But I also do not find it especially expensive, if earnings are maintained at their current level.
Room for growth
Indeed, FTSE 100 engineer Spirax-Sarco has a P/E ratio more than double that. Rolls-Royce shares could double from their current price and still be cheaper than Spirax-Sarco using this metric.
The two engineers have different business models and the expensive Spirax-Sarco valuation is actually the main reason I have not added that share to my portfolio already. But I think the comparison illustrates the point that, if Rolls-Royce shares doubled from here, they would still be trading on a valuation that we can already see in today’s market for other companies.
Possible earnings drivers
I said above that I thought the current valuation is reasonable if earnings are maintained. That is the rub, for better or for worse.
Historically, the engine maker has struggled to deliver consistent earnings. Big contract wins, swings in demand, and the high costs of developing engines have led to large jumps from one year to another. That included sometimes recording a sizeable loss.
I see a risk that current earnings may not last. For example, a sudden slowdown in demand could hurt revenues and profits as it did during the pandemic. Supply chain problems could hurt profitability, a problem that has plagued Boeing in recent years.
If that happens, I think Rolls-Royce shares would likely fall from their current level.
On the other hand, if earnings grow, I see plenty of scope for the shares to move up from here in coming years – and even double.
Tempting, but not for me
The company has set out ambitious performance goals that ought to see earnings grow in the medium term, if they are delivered.
On a 2027 timeframe, the company is targeting underlying operating profit of £2.5bn–£2.8bn. The top end of that range is 76% higher than the equivalent figure reported for last year.
Underlying operating profit and post-tax profit are not the same. But broadly speaking I would expect earnings to move up if underlying operating profit does, over a number of years.
A jump of three quarters in a few years could merit a price premium for delivering ambitious goals, so if that happened I could see Rolls-Royce shares doubling.
The risk of another sudden collapse in demand sits uneasily with me at the current valuation, though. So I will not be investing.
