Why have Rolls-Royce shares fallen this week?

Rolls-Royce (LSE:RR) shares are up 178.5% over the past 12 months, but have fallen 3.1% over the past week. In fact, it’s not unusual for stocks, even those that are doing incredible bulls, to go backwards. But this was different. Earnings fell from 432p per share to 398p. That’s quite a dip. Let’s take a closer look.

Defense back

Shares in defensive stocks fell in the week beginning April 8 as analysts suggested the sector may be under-crowded – too many investors taking the same strategy. European defense stocks have done the unthinkable over the past two years, and that is closing the valuation gap with their US counterparts.

European companies, including defense stocks, have long traded at a discount to their American counterparts. Yes, the US stock market gets more attention than UK and European exchanges, but these payments have traditionally reflected the fact that European countries have often shied away from their 2% NATO spending pledges.

All this changed when Russia invaded Ukraine. European countries have increased their defense spending and have also been providing emergency aid to Ukraine.

The pullback reflected concerns that Europe’s defense stocks may be getting a little expensive. I would also suggest that Lord Cameron’s meeting with Donald Trump – who says he will end the war in Ukraine if elected – added fuel to the fire.

A little too much?

In 2023, almost a quarter of Rolls-Royce’s revenue came from the defense sector. The London-based company is a leading manufacturer of engines for the military transport market and the second largest provider of aero-engine products and services worldwide. These are big ticket items, not like bullets and guns.

Personally, I think the sale of Rolls-Royce shares was likely overdone. After all, defense is not the biggest part of the company’s business and Rolls previously suggested that the war in Ukraine had no impact on earnings. My interpretation is that Rolls benefits from broader geopolitical tensions, and long-term defense contracts, such as the AUKUS program.

The story continues

Appreciation

Of course, the above leads us to ask whether Rolls-Royce shares are overvalued. And in my opinion, it is not. The aerospace giant currently trades at 23.25 times forward earnings, and this figure drops to 19.2 in 2025, and finally 16.2 in 2027 – that’s as far as the forecast goes.

This puts it at a significant discount to its peers GE The skywhich trades at 40 times forward earnings. GE’s price-to-earnings ratio falls to 31.4 times in 2025 and finally to 25.4 times in 2027. It is more expensive than the rest of the UK company.

The bottom line

Rolls-Royce is a company with many positives and not many challenges at the moment. If I were to be critical, I would suggest that the company relies too much on its aerospace division as the disaster – a unique situation – showed.

Personally, I still see Rolls-Royce as a stock with great potential. It’s cheaper than GE Aerospace and all three of its business units – including defense – are booming.

Post Why have Rolls-Royce shares fallen this week? appeared first Motley Fool UK.

Read more

James Fox has a position at Rolls-Royce Plc. The Motley Fool UK has recommended Rolls-Royce Plc. The opinions expressed on the companies mentioned in this article are those of the author and therefore may differ from the official recommendations we make in our subscription services such as Affiliate Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that focusing on a wide range of knowledge does We are the best investors.

Motley Fool UK 2024