£20,000 invested in Rolls-Royce shares 5 years ago is now worth £220,000! What’s next?

As I write, Rolls-Royce (LSE:RR) shares are up 999.8% over five years. This means a phenomenal 10-times return for anyone who made an investment five years ago.

So, why has this happened and will this run continue?

In short, it’s because three big forces all hit at once. The company underwent a deep internal overhaul, saw a powerful recovery in its end markets, and initiated a period of financial discipline.

After years of underperformance, the company got serious about fixing its balance sheet and streamlining operations. Management cut costs, simplified the business, sold non-core assets, and focused on cash generation rather than R&D for its own sake.

Investors had been waiting a long time for that shift, and once the benefits started showing up in the numbers, confidence returned quickly.

At the same time, civil aviation came roaring back after the pandemic. Rolls-Royce earns money based on how many hours its engines fly, so more long-haul travel directly boosted revenue. Defence has been another quiet engine of strength, with geopolitical tensions creating a deep book of military engines and support contracts.

And then there’s execution. Rolls-Royce has repeatedly upgraded profit and cash-flow guidance. And with every upgrade, the market has had to reassess its valuation of the FTSE 100 company.

Coupled with Rolls-Royce’s supposed technological superiority in small modular reactors (SMR), these factors have transformed sentiment.

For context, three years ago it was around the 60th-largest company on the index. Today it’s the fifth. That goes to show how far it has outperformed.

Ok, what’s next?

I appreciate readers will often find valuation metrics the boring bit. But they’re also the most important bit. At 37.8 times forward earnings, the stock is trading towards the more expensive end of the industrials segment. The growth-adjusted metric price-to-earnings-to-growth (PEG) ratio of 2.8 (traditionally one is a sign of value) confirm this.

So, it’s expensive. But the caveat is Rolls-Royce is quite unique. Making aircraft engines and propulsion systems is a very hard industry for anyone to break into. The competition threat is pretty low. That affords it a premium valuation — roughly in line with peer GE.

However, my thoughts are twofold. The company’s valuation has already baked in a lot of growth expectations. A re-rating — when the market changes its valuation of a company, causing its price to rise or fall significantly without a corresponding change in its current earnings — isn’t on the cards.

Instead, the company needs another catalyst to get the share price moving upwards again. That could be beating earnings expectations and raising guidance again. Or it could be more good news on the SMR front.

I believe it’s worth considering, but the margin of safety is much lower than it has been. I’ve been buying Melrose Industries as my preferred industrials stock this year.

The post £20,000 invested in Rolls-Royce shares 5 years ago is now worth £220,000! What’s next? appeared first on The Motley Fool UK.

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James Fox has positions in Melrose Industries Plc and Rolls-Royce Plc. The Motley Fool UK has recommended Melrose Industries Plc and Rolls-Royce Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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