A year ago I thought Rolls-Royce Holdings (LSE: RR.) shares were looking a bit toppy. But in the 12 months since, they’d still have boosted a £10,000 investment to around £18,400.
Over the past five years the Rolls-Royce share price has skyrocketed by nearly 530%. And that could have turned £10,000 into about £63,000 today.
I’ve been watching broker forecasts and price targets with some scepticism. It seemed to me as if they just lift their targets at random every few months, even with no news about how things are going at the company. But they’ve been right so far.
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The right valuation?
I can understand how forecasts for revenue, earnings per share (EPS) and all the other fundamentals come about. But how that translates to share prices depends on one unknown. What’s an appropriate price-to-earnings (P/E) valuation for a stock? That’s not an easy question to answer.
At the moment, we’re looking at a forecast P/E of 32 for the year ending December 2025. After the way the share price has soared, is that high? Compared to a current FTSE 100 P/E of about 18, it looks that way. And that index value (which varies depending on who we ask) is above its three-year average of 15.
Comparing with UK sector rivals is tricky because there are so few of them. BAE Systems has a forecast P/E of 23. And compared to that, the Rolls-Royce valuation looks a bit steep. And as forecasts suggest almost the same percentage growth in EPS between 2025 and 2027 for the two, there’s no growth premium here for Rolls.
Global business
The aero engine business is truly worldwide. So maybe the trick is to compare Rolls with international competitors. A look at forecasts for GE Aerospace shows a forward P/E of 35. RTX, the aerospace giant that owns Pratt & Whitney, is on a multiple of 27. They make the Rolls P/E of 32 perhaps look about right.
What about a rational valuation based on expected cash flow? My colleague at The Motley Fool Simon Watkins reckons a discounted cash flow analysis puts Rolls-Royce shares at around 35% undervalued. Of course, forecasts change, often fairly rapidly.
My main conclusion is that it’s far harder to work out a fair valuation for a growth stock like Rolls-Royce than for most others, like mature dividend stocks for example. And it’s that uncertainty that shifts me more towards the latter.
So what’s it worth?
The average price target among City analysts right now is pretty much bang on the 790p share price as I write. That would turn a £10,000 investment into, well, approximately £10,000. It seems wildly at odds with 70% of brokers rating Rolls-Royce a Buy.
Still, the high end of the target range, at 1,150p, would lift £10,000 above £14,500. But there’s a very bearish prediction out there too, at just 240p. That would see our £10,000 slashed to only £3,040.
I’m more confused than I was a year ago. But with the overall bullish stance, I still think growth investors should consider Rolls-Royce shares today.
