There aren’t many stocks on any global market that are up 420% in the past two years. But this FTSE 100 mega-cap aerospace engineer just doesn’t know when to stop!
Yes, I’m talking about Rolls-Royce (LSE:RR). When the stock hit a new yearly high of 485p in June, I thought it had run its course. I sold my shares soon after, expecting a strong correction.
And yet here I am considering whether I jumped the gun… and if I should buy back in?
How high can it go?
Rolls has exhibited signs of faltering briefly in the past two months. It dropped by around 11% through the first few weeks of July. But last week’s announcement that it’ll start paying dividends again in 2025 boosted it right back up to 480p.
The aerospace and defence giant said it’ll funnel 30% of its underlying earnings after tax back to shareholders. If earnings continue as they did in the first half of this year, that would be around £440m — about 1% of its market-cap.
Dividend-wise, that’s not incredible. But it reveals the company’s faith in its ability to keep turning a profit — and rewarding shareholders. It’s probably playing safe to start with, so who knows how much higher it could go. Between 2004 and 2014, the company paid a reliable and consistently increasing dividend and will likely aim to return to that strategy.
Risk… or reward?
Strong earnings aside, there’s only so much buying power behind any stock. At some point, it has to dry up, right? The Rolls share price has practically gone parabolic over the past few years. If history’s taught me anything, it’s that parabolic growth is unsustainable. And yet, here we are.
Despite the growth, the shares are still undervalued by 56.7% based on future cash flow estimates. If the price was struggling to recover previous highs I’d understand. But it’s not. Even the price-to-earnings (P/E) ratio remains low, at 16.8.
But looking ahead, earnings ARE expected to fall, meaning the forward P/E ratio could climb to 26.3. So there are some signs of a potential ceiling that the price could hit in the coming 12 months. At 26.3, the P/E ratio could be above rivals BAE Systems and QinetiQ, putting pressure on further growth.
QinetiQ’s another defence stock I recently sold, believing its gains had run their course. It’s up a further 6.3% since. Was I overly hopeful about peaceful resolutions to the ongoing conflicts in Ukraine and the Middle East?
It seems so.
Where to from here?
Quite frankly, I’m at a loss trying to evaluate Rolls-Royce. It very well could buck the trend and keep climbing. But risk-averse investors like me don’t like when stocks act out of the ordinary.
For now, I’m happy with the returns I secured. Yes, I may miss out on more, but I’d rather play it safe. I’m still very bullish on Rolls’ long-term potential and hope to buy back in at a lower price.
But if I don’t get that opportunity, so be it.
