Are Rolls-Royce Shares Set To Roll Over?

15th Sep '12 by UK Value Investor

7 comments 10693 reads

Everything seems to be going so well for Rolls-Royce (LON:RR.) So well in fact that, as you may have seen, the company recently had a royal visit to a factory in Singapore where another exceptional engine was unveiled to the world. However, although Rolls-Royce have done exceedingly well in the last decade, Rolls-Royce shares have done even better.

In the last decade, turnover has gone from £5.8 billion to £11.1 billion; profits have gone from around £200 million to over the £1 billion mark, and dividends have gone from 8p per share to more than 17p. Overall the company’s growth rate has been upwards of 10% a year, an exceptional figure for a FTSE 100 listed company whose market value is more than £15 billion.

You can see the results of this outstanding decade below:

You’ll have to ignore the manic earnings swing of 2008/9, which was currency related and didn’t show up in the adjusted, underlying EPS figures. The turnover and dividends show the underlying picture of steady growth much better.

In the last decade the company has roughly doubled its ability to generate sales, profits and cash dividends for investors; but that is literally nothing when compared to the returns from Rolls-Royce shares.

Unbelievable shareholder gains

In 2002 you could have picked them up for less than 200p each. If you were a really serious bargain hunter then you may have loaded up with Rolls-Royce shares at the incredible price of 69p in March 2003.

Since then the shares have risen to more than 800p, almost touching 900p a few weeks ago. That’s a gain of more than 300% in the last decade, even without taking dividend income into account.

If you had bought the shares for less than 80p at almost any time during March 2003, and then sold at more than 800p at any time since March this year, then you would have found the mystical “10-bagger”, and generated over 900% profit in only 9 years.

The more they rise, the further they have to fall?

I wrote about the bubble in defensive stocks recently, and I think that Rolls-Royce shares may be a prime example of this particular bubble.

The underlying company is definitely defensive. It’s large, global, robust, diversified and carries little debt. It’s a great global success story with a consistent ability to grow year…

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siestainvestor

16th Sep '12

Can't fault the thinking in this article. But the Editor ought to know that Rolls Royce motor cars (as photographed) are part of BMW and nothing to do with RR. the quoted company

UK Value Investor

Hi Siestainvestor, thanks for pointing that out. I didn't pick the image but I'll ask the Stockopedia editor if it can be changed to an aeroplane engine, or logo or something appropriate (even though it's a nice shot of a Phantom).

marben100

Good article and I agree that it would be risky to invest in Rolls at the current price, despite its excellent track record. However, I question the applicability of CAPE in situations like this.

The whole point about CAPE is that it is designed to even out cyclical swings. However, whilst Rolls has been subject to cyclical swings over the last 10 year period, it has also achieved considerable secular earnings growth. Hence I don't see how a metric that averages earnings over the last 10 years is particualrly useful in a situation like this. Future earnings are not likely to revert to the figure of 10 years ago and I see no reason to believe that Rolls relative earnings outperformance over the last decade is going to turn into underperformance in the next one (i.e. mean reversion).

So, personally, I wouldn't be guided by CAPE here but I do feel that a historic P/E of over 18 is a bit rich. In that vein I'll just note that the graph shown on Stockopedia's stock report for RR (in the "Graphical History" section) which shows how the company's P/E has varied over the last 5 years is IMO more useful and shows that the P/E that the stock is currently on is towards the upper end of its historical range, implying "expensive".

18th Sep '12

I think CAPE is a valid tool for valuing any company, regardless of whether it's cyclical or not. The price relative to the past 10 year's earnings can give you an idea of what you'd be paying relative to the next 10 years earnings.

So a company that is non-cyclical, say Reckitt Benckiser, will normally have a relatively high CAPE because the next decade's earnings are virtually certain to be materially higher than the previous decade's. An above average CAPE in this case isn't necessarily a bad thing, although even non-cyclical business can have a CAPE which is 'too high'.

A company like M&S, which is somewhat cyclical, should probably have a lower CAPE than RB, and usually does because investors are less certain that the next decade will be substantially better than the last.

With Rolls Royce on a CAPE of 30, investors are assuming that the next decade's earning are going to be very much higher than the last decades. This may be true, but then again it may not. They are taking a substantial bet on a rosy future which is an investment strategy that does not have a good track record.

I would say that CAPE, like any quantitative metric, should not be used in isolation. It should be used only in conjunction with considerations about a company's cyclical nature and potential growth rate.

As for PE, yes that's a good tool, but only as long as you look at multiple years (as you say) and not just the last year - in case last year's earnings were especially high or low which of course distorts the PE.

Edward Croft

Interesting from Stuart Mitchell Capital on Rolls...

We bought a new position in Rolls Royce. We feel that the market is underestimating the value that Rolls Royce gleans from its long-term “Total Care” service packages, which will drive future earnings surprises. The very supportive airframe build market also makes us feel confident in this new position.

We funded the purchase with the sale of our investment in Sky Deutschland and the reduction of our holding in Altran.

But also this comment...

The current anxiety around the Euro is creating an extraordinary opportunity to buy ‘world leading’ European companies at compelling valuations. The market is, in fact, currently trading on some eight times prospective earnings, valuations we haven’t seen in four decades. European equities are, furthermore, trading at over 40% discounts to their US counterparts, the widest gap in living memory.

More here: http://swmitchellcapital.com/news/august-1-2012

Hi Ed, well I wish them good luck with Rolls, but I'd expect a much better entry point at some future date. As for Europe (I guess they mean continental), I agree, valuations are compelling, which is why I'm surprised they chose Rolls rather than a European 'world leader'. I'll wager 50p that Rolls Royce's CAPE is lower 5 years from now than it is today.

brucepackard

10th Nov '15

This is a great post, from a 2015 perspective. Spot on.

Are Rolls-Royce shares set to roll over?

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