Are Rolls Royce shares still a buy after gaining nearly 1,000%?

From the post-pandemic low around 39p, Rolls Royce shares (LON:RR) have rallied nearly 1,000%. We look at the key factors determining whether the stock should still be considered a ‘buy’ after the portfolio-making ascent.

The threat of grounded planes for extended periods due to the spread of the coronavirus ravaged the engineer’s share price. The company relies on flying hours for revenue; this evaporated in 2020, and investors scrambled to the exit, sending the Rolls Royce share price below 40p.

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This proved to be the buying opportunity of a lifetime.

For many investors who bought Rolls Royce in the depths of 2020 and are still holding it, Rolls will be the best investment they will make in their life, certainly in an FTSE 100 stock.

Whether Rolls Royce continues to rally from here boils down to valuation. The recovery from the pandemic is an old story, and we know very well consumers are choosing to allocate their discretionary spending to travel. The dynamics that underpinned Rolls Royce’s meteoric rise are intact.

The stock is no longer a recovery play. Far from investing in a recovery, investors now must consider the company’s growth potential and whether the underlying fundamentals can support earnings growth, as well as the current earnings multiple.

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Trading at 29x historical earnings, Rolls Royce is overvalued compared to peers, and the wider benchmark, on an earnings basis. Earnings are a very simplistic method of valuing a company, but investors of all levels will refer to it when trying to justify an investment case. The question for investors is whether Rolls Royce can bring this multiple down by increasing earnings in the future.

Judging by the company’s latest investor presentation, this is very much a possibility, but Rolls Royce has a lot of work to do to justify the current share price.

Rolls Royce has set out ambitious profitability targets supported by a robust strategic framework. The company is setting out to materially expand it civil aerospace business unit and build foundations in the power generation business.

The company targets £2.5bn—£2.8bn operating profit by 2027 and a return on capital of 16-18%. To meet their targets, Rolls Royce will need to nearly double operating profit from the 2023 full year and dramatically increase operating margins.

Rolls Royce have taken the difficult decision to reduce headcount in the pursuit of higher margins and this has been rewarded by the market.

However, the market appears to have already priced in future targets, which leaves the stock vulnerable to performance which doesn’t deliver on Rolls Royce’s goals.

This vulnerability doesn’t make Rolls Royce a sell but investors must question whether the current valuation justifies future earnings and how much more upside the shares have in them.

Brokers generally have price targets above the current price, but not much higher.

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