The stock market correction of February impacted a majority of the FTSE 100 stocks. In line with that, the Rolls-Royce (LSE: RR) share price fell sharply too. To penny stock levels, in fact. But here is the stock’s challenge. The index has not just recovered since, it is almost back to its pre-pandemic highs. Rolls-Royce shares, however, are still languishing at penny stock levels.
Why are Rolls-Royce shares at penny stock levels?
I reckon this was bound to happen. When I last wrote about Rolls-Royce around two months ago, its high valuations were a concern to me. It had just released its results. And while it posted a profit, the number itself was relatively small. As a result its price-to-earnings (P/E) ratio was at around 80 times. Even for financially strong and growing companies, this kind of market valuation is hard to digest. It is even more so for Rolls-Royce, which has just managed to ride out of a difficult past and whose future is still somewhat uncertain.
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Even after the decline, its P/E is still at 60 times. In comparison, the FTSE 100 ratio is at 15 times. Just on the basis of valuations, I struggle to justify a reason to buy the stock. It does not help that analysts are turning bearish on it as well. JP Morgan has slashed its price target to 75p, which is even lower than the last closing price of 90p.
The upside
This is just one side of the picture, however. According to the Financial Times, analysts on average expect a close to 40% rise in its share price in the next 12 months. The company itself is moderately optimistic as well. In its outlook for this year, it has said that it is confident it “will see positive momentum in..financial performance in 2022 despite the challenges and risks around the pace of market recovery, global supply chain disruption and rising inflation”.
Macros are risky
Speaking of inflation, though, I should dwell on the risk for a moment. This is especially so after the UK saw a massive inflation of 7% on a year-on-year basis in March. Rolls-Royce’s biggest revenue generator is its civil aviation business, which has already taken quite the hit during the pandemic. The rising cost of living could impact it further as demand is impacted while costs rise. Forecasts for economic growth are being slashed too.
It has managed a profit in the past year despite this segment reporting losses, to be fair. But I am not sure if it can pull off another such year. And this is not just because of expectation of weaker demand. Coronavirus is not out of the picture yet. Shanghai, for instance, is in lockdown again. So the risks to travel stay. I would steer clear of Rolls-Royce shares for now.
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