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Rolls-Royce (LSE:RR) shares have been on an impressive run for some time now. The company's valuation has risen thanks to strong earnings growth and continued demand in key industries, including power systems and defense.
The price has almost doubled in the last 12 months alone and sits at £5.86 as I write on 17th January.
The gains have not been fleeting either. A valuation rise of more than 500% since the start of 2023 has boosted the group's market capitalization to almost £50bn.
With this recent growth and momentum, I thought I would evaluate the company's recent performance and several things I would consider before purchasing.
Strong performance in 2024
Last year, investors weren't buying Rolls-Royce shares on a whim. The company's strong share price gains were driven by strong financial results and the achievement of key strategic priorities.
Half-year underlying operating profit of £1.1bn and underlying operating cash flow of £1.2bn reflected strong operating results and continued value creation in both new and existing markets.
Management also raised its full-year guidance despite supply chain challenges, forecasting underlying operating profits of between £2.1bn and £2.3bn and free cash flow of £2.1bn-2.2bn.
Investors should also be happy to see the restoration of distributions to shareholders. The company expects to start with a 30% underlying profit after tax ratio, with an ongoing payout ratio of 30%-40%.
Valuation
I always wonder if a company is overvalued, undervalued, or priced right. I think this is especially important for Rolls-Royce given how loaded the stock has been recently.
Let's start with the price-to-earnings (P/E) ratio. The stock is currently trading at a multiple of 21.2, which is a premium to the FTSE 100 average about 14.5. That in itself is not a problem, as P/E ratios will vary by industry.
For example, investors might be more willing to pay for a defensive company than those in cyclical sectors.
However, Rolls-Royce seems a bit expensive. BAE Systems has a P/E ratio of 20.3 as I write, while on the other side of the Atlantic Lockheed Martin it trades around 17.6.
The restoration of dividends, improved full-year guidance and strong free cash flow generation are certainly factors. However, I am wary of buying shares at the current level despite the generally positive outlook.
Risks and opportunities
The company itself has not shied away from the supply chain challenges it faces at the moment. A continued disruption could impact production and costs, hurting margins and profitability.
International relations are in a delicate balance as we head into 2025. Any additional shocks or unexpected actions by the incoming Trump administration could have serious impacts on defense spending and contracts.
On the positive side, Rolls-Royce stands to benefit from deglobalization and efforts to bolster national security around the world.
If management can continue to execute its strategic objectives and keep costs under control, shareholders could reap the benefits.
Verdict
There are several things I think investors should consider before buying Rolls-Royce stock. While I wouldn't be surprised to see the company's share price rise further, I won't be buying.
The stock looks a bit expensive and is exposed to a fragile geopolitical environment. I am more interested in defensive industries such as pharmaceuticals to complement my current portfolio.
