Rolls-Royce Shares (LSE:RR) are up an impressive 37% over the past year, hitting new all-time highs at the start of July. However, the focus now is on the future. Given £1k to invest, would an investor be more likely to expect its value to rise to £1.5k or fall to £500 next year?
Case for further evaluation
Let’s start with the arguments in favor of continuing the rally. The company continues to benefit from several strong factors that show little sign of fading. For example, the recovery in long-haul air travel has led to an increase in flight hours, which is critical because the company makes most of its money by servicing aircraft engines rather than selling them directly.
As airlines continue to expand international routes, the highly profitable aftersales business should continue to generate strong cash flows. This should lead to higher earnings, which could send the stock higher.
In addition, CEO Tufan Erginbilgic has transformed the business much faster than many investors expected. I’m talking about everything from cost savings to improved operating margins.
There’s nothing to say it’s over. Management has the potential to undertake another round of leadership updates. Of course, the stock isn’t completely undervalued, but investors may once again conclude that analysts are underestimating the company’s earnings potential.
The final opinion on this matter belongs to the defense. With defense spending rising across Europe and excitement growing around Rolls-Royce’s small modular reactor ambitions, there are plenty of catalysts that could justify another 50% increase.
Some concerns
In fact, he is arguably stronger today than he has been for many years. The problem is that the share price already largely reflects this optimism.
Rolls-Royce is trading at a much higher price than in most historical periods. The price-to-earnings ratio is currently 47.09, easily double FCS index 100 average. I don’t think it will take much to trigger a decline, be it a modest loss of earnings or some update indicating a slowdown in engine flying hours.
External risks should also be taken into account. The global economic downturn could reduce demand for international travel, and new supply chain disruptions could delay aircraft deliveries and engine maintenance schedules. This is something we’ve seen not too long ago, so there’s no point in citing such an outlandish risk.
Bottom line
Even with a lot of risk, I simply can’t expect the stock to drop 50% in the next year. I think there are many investors (myself included) who will be willing to buy any dip before the stock price drops that much. Although I think a 50% return is also a bit ambitious, I am inclined to think that a £1k investment next year will be worth more than the original amount and should therefore be considered by investors.