The value of aeronautical engineer Rolls-Royce (LSE: RR) has been gaining altitude quickly. Rolls-Royce shares are up 65% since October. They are still 6% below where they stood a year ago, but the recent rapid climb suggests they have been benefitting from some positive momentum.
Could they go higher from here – and what does it mean for my own stake in the firm?
For the past three years, Rolls-Royce shares have been dogged by concerns over demand for civil aviation. Pandemic restrictions meant far fewer passengers took to the skies. Demand has been returning gradually but remains below pre-pandemic levels.
With China recently opening up again, many investors are hopeful that global civil aviation demand is on track to get back to its former level, and perhaps beyond. That should be good for Rolls-Royce in more ways than one. Servicing revenues for its installed base of engines should increase as the number of flying hours grows. There is also the prospect of higher sales for new engines, if airlines add many more flights to meet surging demand.
Rolls-Royce cut costs during the pandemic and has been selling assets, helping the firm to reduce the debt on its balance sheet. The positive impact of those moves on the company’s finances will hopefully become more obvious as revenues ramp up.
Valuing the shares
I think the strong price growth we have seen in Rolls-Royce shares lately reflects City optimism that the company can now benefit from its strong position in the engine industry.
Indeed, that is the only explanation I think can justify the share price jump.
Last year, the company made a post-tax profit of £124m. Based on that, its current market capitalisation of over £9bn looks excessive.
I think the valuation makes sense only if it is treated as anticipating significantly higher future earnings. I reckon that is possible. Sales growth and inflation could help to boost revenue. A leaner cost base should be good news for profit margins.
Can that help propel Rolls-Royce shares higher still? I think it may. But whether that happens depends partly on how well Rolls is able to perform commercially.
Substantial further price upside this year may depend on the company staying on track with its current production as well as securing sizeable new orders. It has been doing well on that score of late, for example in its power division. It saw a record order intake in the four months to the end of October.
But whether that commercial momentum will stay strong remains to be seen. Cost inflation could eat into profitability.
It remains to be seen whether the firm’s previous cost cuts affect efficiency as the company increases production levels. There is also a risk that airlines will be frugal when it comes to ordering new aircraft, as many have balance sheets still scarred by the pandemic years.
Such risks could see Rolls-Royce shares move into reverse.
On balance, I am upbeat about the firm’s outlook and think 2023 could see further increases in the value of my Rolls-Royce shares. I have enough for my risk tolerance already though, so will not be buying any more.
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C Ruane has positions in Rolls-Royce Plc. The Motley Fool UK has no position in any of the shares mentioned. 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, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.