For the best part of the past three years, the Rolls-Royce (LSE:RR) share price has been on a tear higher. Even in the slower past year, the stock has risen 39%. However, it’s pretty flat over the past six months, which is causing some to wonder whether the rally’s largely over. Yet even if this is the case, I don’t see it as a bad thing. But why?
Shifting from growth to income
Over the past few years, the stock has been mainly bought by investors seeking capital appreciation. The turnaround under CEO Tufan Erginbilgiç has been extraordinary, with the company transforming from a pre-pandemic basket case into one of the FTSE 100’s strongest performers.
Yet as we stand now, I think a lot of the excitement around the company has been factored into the share price. From a valuation perspective, the price-to-earnings ratio is 40.51. This is well over double the index average. Therefore, further gains could be harder to come by.
Yet as someone who has been investing for many years, I think it could be a good thing if the rally’s now coming to an end. Once a company matures after a major recovery jump, management often shifts its focus from rising share prices to rewarding shareholders directly through larger dividends and buybacks. In my view, Rolls-Royce increasingly looks like it’s entering that phase. For income investors, it could become very interesting.
The dividend potential
The company generated £3.3bn of free cash flow in 2025 and expects that to rise to as much as £3.8bn this year. Just as importantly, Rolls-Royce has returned to a strong net cash position after years of balance-sheet stress. For those who think back, it’s a dramatic change from the Covid years, when the business was fighting for survival.
In 2024, dividends were reintroduced, and payments increased significantly last year. Stock buybacks have increased as well. Even though the current dividend yield is only 0.83%, the moves around buybacks and higher dividends aren’t the behaviour of a company desperately hoarding cash. It’s the behaviour of a business becoming financially mature and highly cash generative.
Looking ahead, the payout ratio remains relatively conservative, sitting at 32% of underlying profit after tax. There’s scope for dividend payments to be ramped up in the coming few years, boosting the yield. Further, with the high valuation, if the share price simply consolidates around this level, it’s not a bad thing. When a stock increases in value, it acts to reduce the dividend yield. So if the stock doesn’t really move but the dividend per share increases, the yield can quickly rise.
Risks to note
Of course, the above situation might not play out. Demand for the Aerospace division is cyclical, and any major slowdown in global travel could hit engine servicing revenues hard. Supply chain problems are still affecting parts availability across the industry. If the share price falls, it’s not good news for anyone.
Overall, I think we could start to see the company transition to higher income, which could make it appealing to dividend investors.
Jon Smith has no positions in the shares mentioned. The Twelfth Magpie has recommended Rolls-Royce plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor and Hidden Winners.
