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Unless you've been living under a rock for the past year, you'll be aware of the mega demonstration in the Rolls Royce (LSE:RR) share price. The 135% increase over the past year means the shares are now trading at 487p.
However, last week, the US bank JPMorganThe firm's research team has raised its forecasts for the company. Its analysts have indicated that further earnings are on the cards. Is this realistic?
Shooting for the moon
In a note published last week by the bank's analyst David Perry and his colleagues, the target price for the shares for next year was raised from 475p to 535p. This is not a guarantee that the shares will trade at that price, but rather reflects the analyst's view.
Perry noted that part of the reason for the increase was the recently released strong set of first-half results. In them, underlying operating profit soared from £673m in the first half of 2023 to £1.15bn this time around. This reflected “the impact of strategic initiatives, with benefits in terms of commercial optimization and cost efficiency across the group.”
Another reason for the expected rise in the share price was the increase in free cash flow. Perry explained that the likely increase in free cash flow over the next year should be due to higher profits, rather than customers simply paying in advance for their orders. Therefore, the increase in cash flow is actually a matter of good quality and not just accounting.
Why am I more cautious?
I take JPMorgan's repricing seriously and agree with the points raised in the strong set of recent financial results.
However, I am a little more cautious given that the stock is now at record highs. I wrote recently that I was being patient and waiting for a downward correction, at which point I would look to buy. This has not yet materialised, but I don't want to rush in with the share price anywhere near 500p.
With a price-to-earnings (P/E) ratio of 35, the stock is certainly not undervalued. With my fair value benchmark of 10, I simply don't think it makes sense to buy now. Of course, there is a chance that the stock will stay at a high P/E ratio for a long time. This is something I have to accept could happen.
In addition, the company noted a “A challenging supply chain environment” which could pose a risk in the future.
Staying alert to things
Don't get me wrong, I think the company is well positioned for the long term. The transformation under CEO Tufan Erginbilgiç has been remarkable. But just because I like a company doesn't mean its stock is a smart investment right now.
So, even though some brokers are raising their target price, I'm going to sit tight. I'll try to wait and buy the stock at a more reasonable valuation.
