Rolls-Royce shares: Can future growth offset its low yield?

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 in the aviation, marine and energy industries.

You can see its financial performance over recent years in the chart below:

In summary:

• 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 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, 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.