Image source: Rolls-Royce plc
It can be hard to remember that the Rolls-Royce (LSE: RR) share price sat in pennies as recently as 2022. This year has seen Rolls-Royce shares hit new all-time highs, heading north of £15.
At the moment, the share price is around £14.78. But could it move higher and potentially hit £20 over the next several years?
Several City firms have a price target of £20 on the shares, though many have less lofty expectations of how Rolls-Royce will perform.
£20 may sound very high. But it is only around 35% above the current share price.
That is not much less than the 27% gain seen in Rolls-Royce shares just over the past year. Over five years, the share price has increased by 935%.
Looking to the future
Past performance is not necessarily a guide to what to expect in future, though.
Just because Rolls-Royce shares are up 27% in 12 months does not mean they will perform as strongly in the coming 12.
Indeed, at the moment, the share price is 50 times earnings. That looks expensive to me even for a proven business with strong ongoing growth prospects.
Clearly, though, the upwards share price trend suggests that not all investors share my scepticism about this sort of valuation.
Why the share could rise further
They could have a point.
Ongoing revenue growth and business efficiencies mean earnings could grow handily in coming years. That means the prospective price-to-earnings ratio could be well below the 50 I mentioned above.
The share price has increased in part because investors like Rolls’ position in areas like defence and power systems, that are likely to see strong growth in customer demand over coming years.
With its substantial installed user base, proprietary technology and world-class reputation, that could translate into much higher profits and free cash flows for the company.
Rolls has set ambitious targets in recent years and consistently beaten them. That reflects a combination of external factors like strong customer demand and internal factors such as financial discipline. If it can keep delivering on them that could help push the share price up.
A 35% rise in the share price to £20 could follow. The first half saw underlying operating profit rise 46% year-on-year and underlying cash flow grow 24%. If Rolls can keep delivering those sort of growth rates in the next couple of years, a 35% share price could make sense.
I won’t be buying at this price!
But such growth rates are hard to maintain — especially for a large FTSE 100 company.
There are factors outside Rolls’ control that could stop the growth story in its tracks. For example, another pandemic or high-profile terrorist attack may see civil aviation demand slump overnight, as has happened in the past.
Meanwhile, defence demand growth could mean much more competition from new entrants to the field, putting pressure on profit margins.
I reckon Rolls-Royce shares trade at a valuation that does not offer me as a potential investor sufficient margin of safety for such risks.
So, although I see the potential for a higher share price, I will not be buying at current levels. Instead, I am turning my focus to what I believe are far more attractively valued growth stocks elsewhere in the market.
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Christopher Ruane does not hold any positions in the companies mentioned.
This story originally appeared on Motley Fool
