Image source: Rolls-Royce plc
It has been a satisfactory year for the shareholders of Rolls-Royce (LSE: RR). In the last 12 months, Rolls-Royce shares have increased in value by 180%.
Yesterday (May 10) they reached their highest point (taking into account the changes in the share structure in recent years).
When a stock performs this strongly, it could be that it is overvalued and therefore headed for a decline. On the other hand, the momentum that has driven the stock so far could push it higher.
Despite its meteoric rise, I think it's possible (though not necessarily likely) that Rolls-Royce stock could still double from here.
The current valuation does not seem unreasonable
A useful starting point is to look at whether the stock currently appears overvalued.
I don't think they are.
The price-to-earnings (P/E) ratio is 15. That's not exactly a bargain. But it doesn't seem particularly expensive to me if income remains at the current level.
Room for growth
Indeed, FTSE 100 engineer Spirax-Sarco It has a P/E ratio of more than double. Rolls-Royce shares could double their current price and still be cheaper than Spirax-Sarco using this metric.
The two engineers have different business models and Spirax-Sarco's expensive valuation is actually the main reason I haven't added that stock to my portfolio yet. But I think the comparison illustrates the fact that if Rolls-Royce shares were to double from here, they would still be trading at a valuation that we can already see in the current market for other companies.
Possible profit drivers
I said earlier that I thought the current valuation is reasonable if earnings are maintained. That's the problem, for better or worse.
The engine maker has historically struggled to generate consistent profits. The winning of large contracts, fluctuations in demand and high engine development costs have caused large jumps from one year to the next. That included, at times, recording a considerable loss.
I see the risk that the current gains will not last. For example, a sudden slowdown in demand could hurt revenue and profits, as happened during the pandemic. Supply chain issues could hurt profitability, an issue that has affected boeing in recent years.
If that happens, I think Rolls-Royce stock would likely fall from its current level.
On the other hand, if earnings grow, I see plenty of room for the stock to rise from here in the coming years, and even double.
Tempting, but not for me.
The company has set ambitious performance targets that, if met, should grow earnings in the medium term.
Over the 2027 time horizon, the company is targeting underlying operating profit of between £2.5bn and £2.8bn. The top end of that range is 76% higher than the equivalent figure reported last year.
Underlying operating profit and profit after tax are not the same. But generally speaking, I would expect earnings to increase if underlying operating profits do, over several years.
A three-quarter jump in a few years could justify a price premium for hitting ambitious targets, so if that happened you could see Rolls-Royce shares doubling.
However, the risk of another sudden collapse in demand does not worry me given the current valuation. So I won't invest.
