Rolls-Royce (LSE:RR) shares are up an impressive 37% over the past year, hitting fresh record highs earlier in July. Yet, the main focus now is looking forward. With £1k to invest, is an investor more likely to have it appreciate in value to £1.5k in the coming year, or fall to £500?
The case for further appreciation
Let’s start with the case for a continued rally. The company continues to benefit from several powerful factors that show little sign of fading. For example, the recovery in long-haul air travel has boosted flying hours, which is crucial because the company earns much of its money servicing aircraft engines rather than selling them outright.
As airlines continue to expand international routes, the high-margin aftermarket business should continue to generate strong cash flows. This should filter down to higher profits, which could act to push the stock higher.
On top of that, CEO Tufan Erginbilgiç has transformed the business far quicker than many investors expected. I’m talking about everything from cost savings through to improved operating margins.
There’s nothing to say that things are finished. There’s potential for management to deliver another round of guidance upgrades. For sure, the stock isn’t exactly undervalued, but investors may once again conclude that analysts are underestimating the company’s earnings potential.
A final thought on this goes to defence. With defence spending rising across Europe and growing excitement surrounding Rolls-Royce’s small modular reactor ambitions, there are multiple catalysts that could justify another 50% gain.
Some concerns
In fact, it’s arguably stronger today than it has been for years. The problem is that the share price already reflects a great deal of that optimism.
Rolls-Royce trades on a far richer valuation than at most historical points. The price-to-earnings ratio is currently 47.09, easily double the FTSE 100 average. I don’t think it would take much to spark a fall, be it a modest earnings miss or some update indicating slower growth in engine flying hours.
There are also external risks to consider. A global economic slowdown could reduce international travel demand, while fresh supply-chain disruptions could delay aircraft deliveries and engine maintenance schedules. This is something we’ve seen not that long ago, so it’s not an outlandish risk to cite.
The bottom line
Even with plenty of risks, I just can’t see the stock falling by 50% in the coming year. I think there are plenty of investors (myself included) that would look to buy any dip before the share price moved that much lower. Although I think a 50% gain is also a bit ambitious, my bias is for a £1k investment to be worth more than the initial amount in the coming year, and therefore one to be considered by investors.
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Jon Smith does not hold any positions in the companies mentioned.
