Image source: Rolls-Royce plc
The bad news for Rolls-Royce Holdings (LSE: RR.) shares is they’ve dropped 22% since February’s 52-week high. Falling more than 20%, that’s technically considered a crash.
But the good news is that shareholders who bought at the end of March 2024 are still looking at a 160% gain. That’s enough to turn a £5,000 investment into a cool £13,200. Not bad for a share price that’s just crashed, right? Oh, and it’s on the back of a 950% increase in the past five years.
Future still rosy?
Why have Rolls-Royce shares fallen so hard? The Middle East conflict and soaring oil prices are the key. Aviation is already suffering, and we don’t know how long it will be before flying gets back to normal. So should we assume that’s all there is to it, and the Rolls share price will get back on track when the fighting is all over? I think that could be a mistake.
The share price climb was inevitably going to slow. The same multi-bagger growth repeating itself over the next five years was never very likely. But there’s a key question when any growth share surge looks like it might be coming to an end. What will happen next? Growth shares often get too high into overvalued territory and then go into reverse. Ultimately, the price settles to reflect the long-term value of the company’s underlying performance.
Right now, that performance looks seriously impressive. At results time in February, Rolls said it expects £4.9bn–£5.2bn in underlying operating profit and between £5bn and £5.3bn in free cash flow by 2028.
Reasons to be cautious?
However, I think we need to be cautious over two key issues. One is valuation. We’re currently looking at a forecast price-to-earnings (P/E) ratio of 30, approximately twice the long-term FTSE 100 average. Admittedly, forecasts suggest it should drop to 22 by 2028. And there’s less of a growth stock premium in that, for sure.
The other unknown is where profit growth is going to come from in the years following 2028. AI is going to keep pushing up demand for energy. And that means huge future profits from Rolls-Royce’s new-generation small nuclear reactors. At least, that’s part of the conventional wisdom.
But we don’t yet know how much that profit is likely to be, or when it will come. It looks like it’s not going to happen before 2030, at least. We have to remember Rolls-Royce’s income is heavily dependent on its aviation business. And I can’t see that changing for quite some time.
What do do?
This strikes me as a perfect time to take stock and re-evaluate Rolls-Royce shares, as it does seem like a time of transition. And I can see why there’s still plenty of enthusiasm over the future. But I think cautious investors might do well to consider other homes for their investment cash.
