Has the Rolls-Royce share price risen too far, too soon?

Has the Rolls-Royce share price risen too far, too soon?

The Rolls-Royce (LSE: RR.) share price has been on a tear. Over the last year, it’s risen a staggering 200%.

There are good reasons for the outperformance, but have the shares climbed too far, too soon? Let’s discuss.

Firing on all cylinders

Recent updates from Rolls-Royce have certainly been encouraging. In May, the company told investors that in its Civil Aerospace unit – which is responsible for around half its revenues – flying hours had returned to 100% of 2019 levels in the first four months of the year. It added that they could finish the year at up to 110% of 2019 levels. This is very good news for investors.

But that’s not the only thing for investors to be excited about. You see, right now, Rolls-Royce is also having a lot of success in its Defence and Power Systems divisions. In Defence, it’s been winning contracts for submarines being developed by the UK and Australia. Meanwhile, in Power Systems, its strong position in the data centre market’s providing growth opportunities.

Overall, the FTSE 100 company appears to be having a lot of success. And its profits are surging. This year, it expects underlying operating profit to range £1.7bn-£2bn. That would represent a year-on-year increase of 25%.

Our work to transform Rolls-Royce into a high-performing, competitive, resilient and growing business is continuing with pace

CEO Tufan Erginbilgiç

One other thing worth mentioning is that the company’s balance sheet’s improved. Recently, the company reduced its debt by repaying a €550m bond from its cash. This has been recognised by major credit rating upgrades such as Fitch and S&P, where it now has an ‘investment grade’ rating.

Has it risen too fast?

Back to my question at the top. Has the stock gotten a bit ahead itself? Well, if I’m honest, I think it has.

For 2024, analysts expect Rolls-Royce to generate earnings per share (EPS) of 15.3p versus 13.8p last year. That means the forward-looking price-to-earnings (P/E) ratio is 30 right now.

That seems high to me. At present, Rolls-Royce is priced like a high-growth software stock. Now if we take next year’s EPS forecast of 18.7p, the P/E ratio comes down to 25. That’s not as bad. But it’s still pretty high.

Maybe I’m looking at the wrong metric though? Last year, Rolls-Royce generated free cash flow of 21.1p per share. So at today’s share price, the free cash flow yield is 4.5%. That’s reasonably attractive.

My gut feeling is that the shares are quite expensive though. Of course, expensive shares can stay expensive. Amazon, for example, has always had a lofty valuation.

Investors need to be careful with these stocks though. If a company trading a high valuation misses earnings forecasts, it can lead to a sharp share price fall.

We can’t rule out such a scenario here in the years ahead. If the civil aviation industry was to slow, the company’s profits could be lower than expected. It’s worth noting here that plane manufacturer Airbus announced a big profit warning yesterday (25 June).

So I’d approach Rolls-Royce shares with caution, at current prices.

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Ed Sheldon has positions in Amazon. The Motley Fool UK has recommended Amazon and Rolls-Royce Plc. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.