Rolls-Royce shares might be 26% overvalued. Is it time to sell?
Although I admit I was late to the post-pandemic party, Rolls-Royce Holdings‘ (LSE:RR.) shares remain the best performer in my ISA. But having been rallying for the past five years â the groupâs share price has increased over 700% since December 2020 â I’m starting to question whether I should sell.
Let’s see.
Like-for-like
A good way of assessing whether a stockâs expensive is to compare its price-to-earnings (P/E) ratio to that of a similar company. With Rolls-Royce this isnât as easy as you might think. Although each of its three divisions â civil aerospace, defence and power systems â have plenty of competitors, I canât find another listed company that operates in all three markets.
The best I can come up with is RTX Corporation, the worldâs largest aerospace and defence company. As well as being a major supplier to the US military, it owns aircraft engine maker Pratt & Whitney. It claims that every second an aeroplane powered by one of its engines takes off or lands somewhere in the world.
Some number-crunching
And using the consensus forecast of earnings per share from analysts for both companies, I think a reasonable argument could be made to suggest â based on their 2027 predictions â that Rolls-Royceâs shares are currently (1 December) over-priced, perhaps by as much as 26%. That’s because its P/E ratio is 28.8 compared to 22.8 for RTX.
| Stock | Share price | Forecast 2025 P/E ratio | Forecast 2026 P/E ratio | Forecast 2027 P/E ratio |
|---|---|---|---|---|
| Rolls-Royce | £10.71 | 37.3 | 32.9 | 28.8 |
| RTX Corporation | $172.46 | 28.2 | 25.1 | 22.8 |
Using their balance sheets, the difference becomes even more stark. Based on its half-year results at 30 June, Rolls-Royce trades on 37 times its book value. By contrast, using numbers for RTX at 30 September, its price-to-book ratio is 3.5.
This is an enormous difference and makes me wonder if the former’s in a bit of a bubble that could burst very soon.
Hang on…
But as well as sometimes being overly cautious, as evidenced by my post-pandemic hesitancy to take a stake in Rolls-Royce, another of my failings is a temptation to bail out too early.
Psychologists call this the ‘disposition effect’. It centres on a common observation that the pleasure of a gain is less powerful than the pain of a loss. The consequence of this is that many investors tend to settle for a modest short-term profit even though they know â deep down â that they should probably take more of a long-term view.
I acknowledge that Covid-19 showed us how vulnerable Rolls-Royce is to a downturn in the aviation market. And I know that some of the groupâs current near-£90m market-cap probably reflects a belief that its small modular reactor (SMR) programme will be a great success, even though the technology has yet to be proven. But despite the groupâs shares not being cheap, Iâm going to resist the pull of the disposition effect and hold on to my shares.
Thatâs because I have faith in the groupâs technology. Personally, I think it will be one of the SMR winners. I also like the fact the group wants to return to the narrowbody aircraft market. In addition, I think its power systems business is likely to benefit from the anticipated rapid growth in data centres. All three of its divisions are expanding and improving their margins.
And for these reasons, others who are prepared to take a long-term view could consider adding the stock to their own portfolios.
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James Beard has positions in Rolls-Royce Plc. The Motley Fool UK has recommended 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.
