Are Rolls-Royce shares set to roll over?

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 after year.

So don’t be in any doubt – I think that Rolls-Royce is a great defensive company and one that I would be happy to invest in at the right price.  But are Rolls-Royce shares worth more than 800 pence each?

At today’s price of 830p, each share has a dividend yield of just 2.1%.  I can get 3.7% (a 76% improvement in income) from the safety of a FTSE 100 index tracker.  The current normalised PE is 18.8, also well above the market’s PE of 11.4.

Looking at the ‘cyclically adjusted’ PE using average earnings over a 10 year business ‘cycle’, I can see another indicator of an overvalued share.  Rolls-Royce shares are priced at around 30 times their cyclically adjusted earnings, while the FTSE 100 is less than half that at under 15 times.

Of course, if Rolls-Royce continues to grow while steadily increasing its dividend, and if investors continue to give the company a lofty valuation, then the shares may still do well in the future.

But let’s look at it another way.  The last time the FTSE 100 was valued as highly as Rolls-Royce is today (at 30 times its cyclically adjusted earnings) was 1999.  Investors had invested in a great asset, namely the UK equity market.  It had grown earnings and dividends consistently well for years and the FTSE 100 had gone from around 2,000 in 1990 to almost 7,000 in 1999.

In essence, the price of the market had risen far faster than its underlying value.

So what happened next?  The value of the market collapsed by about 50% and we are still not above 7,000 today, more than 12 years later.

I’m not saying that this fate awaits Rolls-Royce shareholders.  But let’s say the shares fell by 50% tomorrow, back to just over 400p.  Just imagine that some bad news came out that was bad enough to trigger such a fall, and yet not really affect the long-term prospects of the company (although the market would think otherwise, extrapolating today’s bad news further into the future than it really deserves).

At 400p, what would we have?

We’d have a big, international, relatively defensive company that can consistently grow at around 10% a year.  It would have a yield of perhaps 4.2%, a PE of around 9.4 and a cyclically adjusted PE of about 15.

Surely investors wouldn’t allow such a fantastic business to trade at such a low PE, with such an attractive yield?

Well, let’s look at Tesco (LON:TSCO) .  It’s a big, international, relatively defensive company with a history of consistently growing at more than 10% a year.  It has a yield of 4.3%, a PE of 10.5 and a cyclically adjusted PE of 14.5.  Almost exactly the same as Rolls-Royce shares would have if the price fell to 400p today.

The bad news for Rolls-Royce shareholders is that Tesco really is that cheap, and there’s no fundamental reason why Rolls-Royce shares can’t fall back to 400p either.

That may sound crazy, but it’s where they were just three short years ago, and they could easily go back there in the next three years.