Rolls-Royce shares have long been a favourite of defensive and income-seeking investors. It’s easy to see why if you look at its long record of inflation beating dividend growth.
The company almost doubled its dividend between 1992 and 2002 and more than doubled it in the following decade. That’s no mean feat for such a large company, but investors are expecting even more in the future.
Today Rolls-Royce shares stand at 1,045p and the dividend yield is just 2.1%. With the FTSE 100’s yield currently at 3.5% investors are expecting Rolls-Royce to continue to grow its dividend significantly faster than the average large-cap company.
And that may actually be a reasonable assumption, but it’s not without its risks.
The company has grown rapidly in recent years
Rolls-Royce has built itself into an extremely successful global business supplying and servicing a variety of engines, motors and power systems into the aviation, marine and energy industries.
You can see its financial performance over recent years in the chart below:
- Revenues have grown by about 10% a year
- Earnings have grown by about 9% a year
- Dividends have grown by about 11% a year
In comparison the FTSE 100 grew those fundamentals by about 2% a year during the same period, not even keeping pace with inflation.
Investors expect that rapid growth to continue
The low dividend yield from Rolls-Royce shares implies that investors are giving up some income today in expectation of more income tomorrow. In other words, rapid dividend growth must be maintained in order to justify the stock’s current high valuation and low yield.
But is market beating growth a reasonable assumption?
I think it probably is. Rolls-Royce operates globally in various markets, some of which are still growing quite rapidly and it has a relatively defensible position as a leading supplier of engines, power systems and related services to those markets.
It has proven itself to be a well-run business and there’s no obvious reason that I can see why that past growth can’t be continued into the future.
If Rolls-Royce doubles in size will the share price double?
The company has stated that it has the potential to double revenues (and presumably earnings and dividends) in the next decade. If that were to happen, what sort of share price gain could investors expect?
The answer would depend on what the market’s expectations were 10 years from now.
One scenario is that 10 years from now both Rolls-Royce and the market expect the company to be able to double in size again in the following decade. In other words, having doubled in size by 2024 the expectation is for it to double in size again by 2034. This would take the dividend from its current 22p to 44p in 2024 and 88p in 2034.
Leaving aside arguments of whether or not it’s feasible for Rolls-Royce to pay an 88p dividend in 2034, it’s reasonable to assume that in this scenario the yield and valuation ratios of Rolls-Royce shares would be approximately the same 10 years from now as they are today. That’s because investors would have the same expectations of the company doubling in size in the following decade as they do today.
If revenues, earnings and dividends doubled by 2024 and yields and valuation ratios stayed the same then the share price would also have doubled.
Doubling in 10 years requires a growth rate of about 7.2%, and adding that to the current yield of 2.1% gives a total return of 9.3% a year for 10 years in this scenario (or a share price of 2,090p in 2024 and a dividend of 44p, giving that same 2.1% dividend yield).
That’s a pretty solid rate of return, assuming the company can keep up the growth over such a long period of time.
But there is another scenario.
What if, after doubling in size during the next 10 years, the company is unable to continue to grow at that rate? Trees don’t grow to the sky and the growth rate of fast growing large companies usually reverts towards the market average eventually.
So let’s assume that Rolls-Royce can double in size by 2024, but from that point forward it can only grow at around 2-4% a year, which is closer to the overall global growth rate as well as that of the FTSE 100.
If a company can only grow at an average rate then it should be given an average valuation multiple and its dividend yield should also be approximately average as well. Currently the FTSE 100 is yielding about 3.5%, and that’s pretty close to its historic average, and so I think that’s a fair value to take as a large-cap average yield.
If Rolls-Royce doubled its dividend to 44p by 2024 while at the same time the dividend yield on its shares increased to 3.5% then the price of those shares would be 1,257p in 2024.
That’s a gain over 10 years of just 20% from today’s price and in fact it’s somewhat below their peak of 1,289p in early 2014.
Conclusion: A solid defensive company whose shares are at risk of disappointing in the longer-term
I’m not saying that Rolls-Royce is a bad investment; far from it.
I think it’s a great defensive company and it has as good a chance as any large company of doubling in size over the next decade. But that expectation is already in the price and if the company doesn’t meet those lofty targets then there is a lot of scope for disappointment.
Having said that, I don’t think it’s overpriced. I think it’s probably fairly priced, especially if you compare it to other large and fast growing companies.
For example, looking at other FTSE-listed companies that have grown between 8% and 15% a year over the last decade, their average dividend yield is 2.6%, their average PE10 is 26.9 (RR’s is 23) and their average PE is 18.8 (RR’s is 17.6).
So Rolls-Royce appears to be in the middle of its peer group in terms of valuation; not especially expensive and certainly not especially cheap.
The problem, as it is with a lot of fairly priced high growth companies, is valuation risk; the risk that the company fails to produce the expected high growth rates causing the share price to rerate downwards by a significant amount.
For me the price would need to get down towards 800p before I’d be interested.
At that level the dividend yield would be around 2.8%, which would significantly reduce the risks of a downward re-rating, and it’s also more in line with what’s on offer from other higher growth but still reasonable yield stocks.
Under The Money Tree says
An interesting take as I was looking at RR a few weeks ago. Their order book is phenomenal but as you alluded to I think their price is a little high for my liking currently.
While thinking about their longer, longer term prospects I wonder if/how the advances in 3D printing will affect their business a couple of decades from now…
John Kingham says
I cannot even begin to guess what’s going to be happening in 20 years time in terms of technology. 20 years ago the web pretty much didn’t exist for ordinary people!
As for 3D printing I think it’s just another manufacturing technology, although it’s pretty amazing what they’re doing with printing metals instead of casting or machining.
Ken Brennan says
Thats very much my view – a quality company at a price to match. Not a screaming buy.
As for 3d printing – no doubt will make some difference but a Rolls fan blade is a work of art and is much more than just its shape. I would be surprised if such high value components could be manufactured by radically other means.
John Kingham says
Hi Ken, You might be surprised by 3D printing. It’s already being used to manufacture large parts of rocket engines:
So I don’t think aeroplane engines are out of the question. But I don’t think it’s a disruptive technology, at least not in this sort of application. It just makes better components more quickly and cheaply than before.
I share this sentiment. RR shares have grown too fast since their 200p price after the crash. The earlier high price at the beginning of this year was far too high and suffered a shock, but it’s not enough. It would have to be below 800 to be of interest.
I see Neil Woodford has allocated 3.5% of his fund to this at probably the 1050 level.
But Neil holds 62 stocks in his fund which is far too many in my simple view.
Rolls Royce is a great company though!!
I was lucky to invest in RR long time ago. My first job in UK was for a precision engineering company and we used to make components for RR. We were not able to keep up with demand, and the guy from RR came every week to pressure us to make more stuff for them. I was doing 75 hours a week on average and that was still not enough.
Some of the money I made I invested in RR shares and I am very happy about that.
Yes, RR shares are more expensive than they used to be. I have trimmed my RR shares by 75% as well.
However you need to be carefull what you compare this company with. The FTSE100 is full of dinosaurs: banks, insurers, miners, utilities, supermarkets etc. There are very few companies that are research and innovation based as RR is: ARM Holdings, BAE, pharma. Comparing with those, RR is quite cheap on some metrics.
Obviously there are risks: a glitch in the design of some new engines, could make some airoplanes to fall from then sky.
I like RR, but prefer Safran. Similar backlog, aftermarket inflecting.
John, It’s getting there, down at 948 and has been below the 1000 a good few days now.
800 is still possible if October turns out to be a nasty month.
John Kingham says
Hi Larry, yes it looks like almost anything is possible. Maybe Rolls-Royce will be a value share in 2015?
RR shares are now 803p. Are you interested now?
John Kingham says
Hi DT, currently RR sits at number 58 on my stock screen, out of about 240 companies, so it’s pretty near the top. I would say it looks like good value at the moment, at least using my quantitative measures.
However, I probably wouldn’t buy it at the moment, and I mean me personally, because there are other companies out there that look like even better value. But if I didn’t know about those other companies then yes, I’d be quite happy to buy RR at these levels.