Rolls-Royce looks expensive – this is why we’re not done buying

Questor is The Telegraph’s stockpicking column, helping you decode the markets and offering insights on where to invest for the past six decades.

Rolls-Royce’s stunning share price growth proves that expensive stocks can still deliver exceptional capital returns.

The FTSE 100 aerospace and defence company’s shares have risen by 54pc since our most recent “buy” recommendation in September last year, yet their price-to-earnings (P/E) ratio is little changed.

In fact, the company’s rating now stands at 40 versus 38.3 six months ago. The vast majority of its share price growth since September, therefore, has been down to an improving financial performance. Indeed, its full-year results, which were released last month, showed that profits increased by 48pc year on year and are set to further rise over the coming years.

The company, for example, expects to deliver a 50pc increase in operating profits by 2028. This equates to an annualised growth rate of around 11pc and means that the stock is on track to generate further index-beating returns even without the aid of an upward re-rating.

The company’s financial performance is set to be buoyed by further cost reductions, aiming to grow its operating profit margin from 13.8pc last year to 15pc-17pc by 2028. Alongside this, it is well placed to benefit from improving operating conditions across its various segments.

Notably, in Questor’s view, the defence industry is at the beginning of a period of sustained long-term growth.

While the sector was previously viewed with a degree of derision by some investors due to its lacklustre track record of growth and apparent incompatibility with fashionable ESG trends, rapid increases in military spending across developed economies mean that it now offers excellent growth potential.

Given that Rolls-Royce’s defence segment contributed 26pc of its total profits last year, the firm should benefit from the sector’s upbeat growth prospects. The company’s financial performance is also set to be boosted by growth in the civil aerospace industry, which accounted for 61pc of its profits last year.

Although US tariffs are likely to have a detrimental impact on the world economy’s near-term growth prospects, monetary policy easing in the US and elsewhere should equate to a more sanguine long-term outlook for consumer spending.

This is likely to prompt higher demand for discretionary items, such as air travel, with global airline passenger numbers forecast to increase by over 5pc per annum in the next three years. As well as increasing demand for the company’s aircraft engines, this should lead to higher maintenance requirements that further benefit its bottom line.

Similarly, the firm’s small modular reactors and exposure to battery energy storage solutions suggest it is in a strong position to capitalise on the world’s push towards net zero. Indeed, the company is well placed to benefit from several secular growth opportunities that could bolster its financial performance over the long run.

Alongside upbeat financial forecasts, Rolls-Royce’s annual results also highlighted that its financial position has significantly improved. It now has a net cash position of £475m, which represents a marked change from a net debt position of £2bn in the prior year. Net interest cover during its latest financial year, meanwhile, was in excess of four.

A solid balance sheet means that the firm is capable of investing heavily across its various market segments to generate growth. It also allows the company to conduct a share buyback programme that is expected to total £1bn in the current year.

Of course, some investors will baulk at the idea of a business buying back its own shares while it trades on an exceptionally high P/E ratio. Such investors may also view the company’s current market valuation as a red flag, given that it suggests there is very limited scope for an upward re-rating.

With geopolitical risks elevated at present, it would be unsurprising if the stock’s price remains highly volatile in the coming months.The company, though, is fundamentally sound and well placed to generate relatively strong profit growth over the long run.

Clearly, locking in a 172pc capital gain since the stock was tipped as a ‘buy’ in this column during October 2018, which represents a 155 percentage point outperformance of the FTSE 100, is naturally tempting. Questor, though, believes Rolls-Royce has further room to run.

Questor says: buy
Ticker: RR
Share price at close: 811.2p