Why’s the Rolls-Royce share price getting so expensive?
Middle-aged white man pulling an aggrieved face while looking at a screen
The Rolls-Royce (LSE:RR) share price may conceivably hit £5 in the coming months with momentum picking up of late. However, some investors may be put off by the headline figures.
Rolls-Royce is now trading at 29.5 times forward earnings, that’s more than double the FTSE 100 average.
I believe investors need to look beyond this rather juicy number. And that might be challenging for UK-focused investors as the engineering giant’s now among the top 10 most expensive FTSE 100 stocks, according to the price-to-earnings (P/E) ratio.
What analysts say
I often find analysts’ share price targets a good place to start. And the average share price target for Rolls-Royce stock is actually 4.3% lower than the current share price.
That’s not a good start, but it’s worth remembering that analysts don’t update their ratings all the time. And that seems to be the case here as there’s only one ‘sell’ rating on Rolls-Royce. By contrast, there are seven ‘buy’ ratings, four ‘outperforms’, and four ‘holds’.
It may simply be the case that analysts are struggling to keep up with the stock’s rise.
It’s all about growth
Stocks in the UK stock tend to trade with high earnings multiples simply because they don’t offer much in the way of growth.
Fundamentally, slower-growth stocks are less attractive to investors because we’re looking to earn money on our cash. Stocks with limited growth prospects typically generate lower future earnings and cash flows.
After all, why invest in a company that’s standing still when there are opportunities elsewhere with higher growth potential?
So it’s a little unusual to see Rolls-Royce trading at nearly 30 times earnings. But it’s simply expensive because it’s forecasted to grow earnings quickly.
The growth trajectory’s very strong with analysts expecting the company to grow earnings by 28.13% annually over the next three to five years.
In turn, this means Rolls-Royce looks cheaper, according to the P/E ratio, as we look further into the future.
Here’s the P/E ratios based on expected earnings.
Moreover, the price-to-earnings-to-growth (PEG) ratio — which is calculated by dividing the forward P/E ratio by the expected medium-term growth ratio — is also rather enticing.
The PEG ratio sits at 1.04. Typically, anything under one is considered great value. Nowadays, investors seem happy to buy anything with a PEG ratio under 1.5.
Priced for perfection?
Some analysts may suggest that Rolls-Royce stock is priced for perfection. I’ve seen some fellow writers say they won’t buy Rolls-Royce stock because of the P/E ratio. Maybe they’re very risk-averse and just don’t like the idea of investing in a company based on its forecasts.
And I do appreciate that Rolls could experience some pullback if Russia’s war in Ukraine came to an end — defence is the company’s second-largest segment.
However, there are always ‘what ifs’. The consensus is that Rolls-Royce will continue to benefit from supportive trends across all three of its main business units. I’m backing the company to keep proving the doubters wrong.
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James Fox has positions in Rolls-Royce Plc. The Motley Fool UK has recommended Rolls-Royce Plc. 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.