Rolls-royce shares have further room to run. But investors should not get carried away

The company’s rich valuation prices in a substantial proportion of its future growth prospects

Stock market investors are particularly skilled at overreacting to both positive and negative news. After a prolonged period of downbeat economic data that included rampant inflation and interest rate rises, equity investors were utterly depressed just a couple of months ago.

Now, though, a fast fall in the rate of price rises means they are suddenly looking ahead with seemingly unbounded optimism to interest rate cuts and an economic boom.

Of course, the reality is that the outlook for shares was never as bad as investor sentiment suggested. Nor is it likely to be as positive as many investors suddenly believe. Interest rate cuts are most certainly on the horizon but could be implemented at a rather leisurely pace. After all, logic suggests that the Bank of England would rather “solve” the problem of inflation and then worry about a recession than be further accused of failing to achieve its primary goal.

So it is imperative that investors continue to avoid overpaying for shares in what could be a volatile stock market. Rolls-royce, for example, now trades on a forward price-to-earnings ratio of around 31 after soaring by 205pc in the past year. Although the company is aiming to more than double operating profits over the next four years, which equates to an annualised growth rate of around 20pc, its shares are unlikely to continue their recent rate of increase. Investors have already priced in a large proportion of its future profit growth.

Certainly, the company is well placed to benefit from underlying trends in its key markets. In civil aerospace, for instance, passenger traffic levels are set to return to their 2019 levels in almost all regions this year before doubling by 2040. Rolls-royce is poised to capitalise on this post-pandemic growth via increased engine sales, with it reporting the first growth in its large engine order book since 2018 in the first half of the year. A greater number of flying hours also equates to higher maintenance income.

In defence, elevated geopolitical risks mean that demand for the company’s military aircraft engines is likely to rise over the coming years. There has been a notable shift in attitudes towards military spending among Nato countries, with 11 members expected to meet the 2pc of GDP annual spending target in 2023 versus just seven members in the prior year. And with defence budgets linked to economic output, the positive effects of falling interest rates across developed countries is poised to directly filter through to higher demand for military products and services. Similarly, the company’s power systems and new markets segments are set to be positively catalysed by the world’s transition to net zero. Alongside this, Rolls-royce is making wholesale changes to how it operates, with it recently announcing headcount reductions that amount to around 5pc of its total workforce and aiming to make sustainable savings of £400-500m by 2027.

Already, this approach has contributed to a vast improvement in profitability. The company’s operating profit margin rose from 2.4pc to 9.7pc in its latest half year, which prompted an upgrade to full-year guidance. It expects to further increase operating profit margins to 13-15pc over the next four years, while growing free cash flow and strengthening balance sheets.

Even at present, underlying net interest cover in excess of five in the first half of the year suggests it can comfortably afford to service existing debts. It also intends to make asset disposals amounting to as much as £1.5bn over the next five years as it

aims to focus on its most profitable and fast-growing segments.

While the company’s shares currently trade slightly higher than when this column first recommended their purchase in October 2018, they have experienced a bumpy ride. Although Questor does not anticipate the scale of volatility during the pandemic to be repeated in future, its path to reaching margin, profits and cash flow targets over the next four years is unlikely to be smooth.

Indeed, while progress has been made thus far, as evidenced in its latest half-year results, much of Rollsroyce’s market value is based on its future prospects. Investors should avoid becoming carried away with the stock’s potential. Further capital gains are set to be delivered but are unlikely to be on the same scale as those produced in the past year. Questor says: hold

Ticker: RR

Share price at close: 308.8p

‘Rolls-royce is well placed to benefit from trends in its key markets. In aerospace traffic levels are set to return to 2019 levels’