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Rolls-Royce (LSE:RR) shares are now trading at 45.6 times expected earnings for the 2025 financial year (which runs with the calendar year).
If you’re new to investing, you may not realise that this is phenomenally expensive for an industrial stock, especially a British one. With that in mind, you might think this stock has run as high as it can go, but there’s a lot to consider here.
Let’s explore.
The king of quality
Quality stocks trade with higher valuations. But this notion of quality has come under a lot of pressure during the AI revolution. Take Auto Trader, for example. No real peers and amazing margins. But it’s now coming under pressure, not by a incumbent, but because of AI.
Rolls-Royce is a bit different. AI isn’t disrupting its business. That’s making aircraft engines, propulsion systems, and reactors. If anything, the business has never looked stronger.
Its moat is structural rather than digital. Certification cycles run into decades, customers are locked in through long-term service agreements, and the installed base generates recurring, high-margin aftermarket revenue.
For example, once a Trent engine is on the wing, Rolls-Royce effectively owns the relationship for the life of the aircraft — a level of visibility and pricing power that few industrial companies can match.
In recent years, this quality status has become clear. The company struggled during the pandemic, but is thriving after a restructuring. Operating margins now exceed 20%.
Valuation is defendable
Rolls-Royce’s valuation is possible to justify, but it’s not simple. It’s growing earrings, with EPS growth forecast around 15.6% over the next 12 months. And it’s sitting on an impressive net cash position — around £1.1bn.
However, everything is relative in the stock market. And Rolls-Royce’s closest peer, GE, trades at similar multiples.
That lack of credible alternatives is doing more work than many investors realise. In large civil aero engines, the market is effectively a duopoly, and in defence and nuclear the field narrows even further.
For global airlines, governments, and utilities, there are simply not many places to go for mission-critical propulsion systems with decades of support behind them.
So while Rolls-Royce may not look cheap on conventional metrics, it is being valued against a very small peer set that shares the same structural advantages.
With GE trading on similar multiples, the market is effectively saying that this is the price of owning one of the world’s few scaled, vertically integrated aero-engine franchises.
The bottom line
Analysts revise their opinions and price targets a few times per year. However, the average share price target is now 7% below the current share price. That suggests that analysts believe the stock is overvalued. However, the majority of analysts still hold a Buy rating on the stock.
This typically reflects the fact that share prices can move faster than analyst models, particularly when sentiment and momentum shift quickly. More price upgrades might be incoming, but that depends on how they assess the current valuation.
Personally, I still believe it’s worth considering for the long run. However, the margin of safety isn’t there due to the valuation. Better options might be available.
