Image source: Rolls-Royce plc
If someone offered to sell me something for 10 or 15 times the price I could have paid just a few years ago, I may feel at risk of being fired. But that's the kind of return you see in Rolls-Royce (LSE: RR) shares in recent years. Having been below 40p at its 2020 low, Rolls-Royce's share price this week remained close to £6.
But while this may be good news for long-term shareholders, what could it mean for an investor like me, looking for value in today's market?
Potentially more to run
In fact, I think the Rolls-Royce share price could go up even higher from here. For starters, its price-to-earnings (P/E) ratio of 21, while not exactly cheap, doesn't strike me as outrageous.
Other FTSE 100 companies have a higher P/E ratio. Fellow engineer SpiraxFor example, it trades with a P/E ratio of 28.
Rolls' P/E ratio is based on past earnings. But your potential earnings may be stronger, potentially much stronger. It is still in the process of carrying out a medium-term transformation program. The demand for sales and maintenance of civil aviation engines is high.
Many Western governments are increasing defense spending. Meanwhile, Rolls' nuclear business may have big sales potential thanks to its line of small modular reactors.
I have doubts, and here's why
Still, while I see arguments as to why Rolls-Royce's share price could continue to rise, I also have some reservations. To begin with, the transformation program remains a work in progress. Rolls is a large, slow-moving and historically unpredictable company in terms of performance. Whether and to what extent that may change permanently remains to be seen.
If cost cutting goes too far, there is a risk of reputational damage. Airline customers pay a premium for Rolls engines because they want complete peace of mind that their planes have world-class engineering on every flight.
The nuclear business might work very well, but people have been saying the same thing about different nuclear businesses for decades, with very different results. I feel this part of Rolls' operations still needs to demonstrate that it can add significant long-term value to the company.
Meanwhile, in the core civil aviation engine business, Rolls has only so much under its control. Historically, one of the biggest challenges has been unforeseen external demand shocks for the airline industry, from terrorist attacks to volcanic clouds and the pandemic. In fact, that explains why Rolls-Royce's share price was in pennies in 2020. The company was on its knees.
I see the risk of similar events happening again at some point in the future, and Rolls can do little or nothing about it. I consider that the current share price does not offer me a margin of safety considering that risk. So while I think the stock can go even higher from here, I won't agree because I have no plans to invest.
