Up 56% in a year, has the Rolls-Royce share price peaked?

In the past year, Rolls-Royce (LSE: RR) has seen its shares rise. In fact, Rolls-Royce’s share price has risen 56% in that period.

Has business been good enough to justify the increase? Or maybe the shares have got ahead of themselves?

Improve business prospects

I definitely think the business outlook is stronger today than it was 12 months ago.

The main challenge in recent years has been the decline in demand for civil aviation caused by pandemic-era government restrictions. That has been raised rapidly and now even markets like China are reopening to international tourism.

With the appetite for civil aviation increasing, the average number of hours each Rolls-Royce engine is in use is set to increase. That should increase profits and profits for engineers. A travel boom could also see airlines order new planes, boosting engine sales.

In addition, the defense industry is growing in demand, especially in Europe. That should increase profits in Rolls-Royce’s defense business.

The rising demand could help the company’s profits. But profits also look set to grow, as the new chief executive focuses on efficiency and implements another cost-cutting program on top of those launched a few years ago.

Share price changes of Rolls-Royce

But while the business outlook has improved, is the change big enough to justify a 56% increase in the share price in a year?

I think the shares were beaten down more than they deserve a year ago, in fairness, so arguably some of the increases are just moving closer to the fair value. But even allowing for that, the shares have moved away. After all, although the company’s prospects look decent, it made a loss of £1.2bn last year. Some are pointing to a weak exchange rate, but the risk will also be present in the future.

In fact, in four of the last five years, the business has lost north of a billion pounds. It is only profitable after tax in one of the years.

Last year it earned £121m. Its current market capitalization is £12.1bn a hundred times – and the company has net debt of £3.3bn to boot. That’s 36% lower than the previous year but still a lot.

Prove your potential

Despite falling 9% over the past two weeks, I’m not sure Rolls-Royce’s share price has peaked. If the business lives up to its potential in the coming months and years, I can see the stock trading at higher levels than it is today.

My concern is that a lot of optimism has been baked into the stock price. I think it is now time for Rolls to show that it can deliver on its potential despite its excellent track record in recent years. This could be a long-term process and right now I don’t see an immediate trigger to push the stock higher. Companies face risks such as inflation eroding profit margins and cost-cutting programs eroding labor productivity.

I have taken advantage of the increase in the price of Rolls-Royce shares to sell my holding. I am now waiting to see if the business starts to grow to its current value before deciding whether to buy the shares again at some point in the future.