Trading Strategies: does Rolls-Royce still offer growth potential?

A Boeing plane over the chalet of engine manufacturer Rolls-Royce at the Singapore Airshow in 2022. Photo by ROSLAN RAHMAN/AFP via Getty Images.

The FTSE 100’s rise to a new record high means that many investors are likely to have sizeable paper profits on some of their holdings. This could tempt them to lock in those gains by selling profitable positions – especially given the uncertain near-term economic outlook.

Indeed, inflation has continued to rise over recent months. It now stands at 3.8%, which is 180 basis points higher than the Bank of England’s target, with the central bank forecasting that it will reach 4% later this year. This could mean that further interest rate cuts are more difficult to justify, thereby failing to provide an additional stimulus for an economy that expanded by just 0.3% during the second quarter of the year.

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Meanwhile, inflation in the US is also sticky. It currently stands at 2.7%, with the Federal Reserve having left interest rates unchanged at 4.25-4.5% since the start of the year. This suggests that the near-term prospects for the global economy could be somewhat challenging – especially when combined with a sharp rise in protectionism.

Long-term growth potential

An uncertain global economic outlook could prompt heightened volatility among FTSE 100 members in the short run. Investors contemplating the sale of holdings that are in profit, though, may struggle to perfectly time any stock market decline. This is because equity markets have historically been exceptionally difficult to predict over a limited time period owing to the infinite number of variables that can affect their performance.

Moreover, investors who sell highly profitable positions now and subsequently struggle to find a desirable entry point may miss out on the stock market’s long-term gains. Indeed, inflation across developed economies is widely expected to moderate over the medium term so that it is in line with central bank targets. This should provide scope for further interest rate cuts that, alongside the effects of previous monetary policy easing, have a positive impact on the world economy’s growth rate once time lags have passed.

Modest market valuations?

While some FTSE 100 stocks may now be showing significant paper profits, they may not in fact be overvalued. Until this year, the UK’s large-cap index had dramatically underperformed its peers across Europe and the US, with the DAX and S&P 500, for example, being up 85% and 84%, respectively, over the past five years versus just 55% for the FTSE 100. This could mean that even stocks showing substantial paper gains have more room to run.

In fact, a substantial number of the index’s members are high-quality companies that may deserve to trade on premium valuations. In many cases, for example, they have sound balance sheets that suggest they are in a strong position to overcome an uncertain near-term economic outlook. Likewise, they may have sound competitive positions that could help them deliver a relatively strong performance over the long run.

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Additionally, investors who sell any holding must consider the alternatives that are available. Given that the FTSE 100 is at a record high, it may be difficult to unearth high-quality companies that trade at a substantial discount to the holdings being sold. Investors who consider other mainstream assets, such as cash or bonds, may find they face significant opportunity costs. After all, falling interest rates mean the returns on cash savings could decline, while bond prices have historically not been as positively impacted by monetary policy easing as equity prices.

A difficult decision

Therefore, while it is naturally tempting to sell holdings that have risen significantly in price as a result of the FTSE 100’s record surge, it may not necessarily prove to be a sound decision. An upbeat long-term economic outlook, modest relative valuations even after the index’s recent gains and potential opportunity costs, mean that the decision to lock in paper profits is likely to be more complex than it appears at first glance.

A high rating

Source: ShareScope on 26 August 2025. Past performance is not a guide to future performance.

Indeed, it may be prudent for investors to consider each of their holdings on a case-by-case basis. For example, aerospace and defence company Rolls-Royce Holdings (LSE:RR.) has posted a 377% capital gain since it was first discussed in this column during November 2023. In doing so, it has outperformed the FTSE 100 by 351 percentage points.

Clearly, many investors may be tempted to lock in the stock’s exceptional gains. After all, the company’s shares now trade on a price/earnings (PE) ratio of 51.8. This is extremely high, even at a time when the FTSE 100 trades at a record level, and suggests there is now limited scope for an upward rerating. Moreover, with the global economy having an uncertain near-term outlook, the company’s share price could prove to be relatively volatile over the coming months.

A high-quality company

However, on a long-term view, Rolls-Royce could offer further capital growth potential. Fundamentally, it is a high-quality company that may deserve to trade at a premium to many of its FTSE 100 index peers.

For example, its recently released half-year results showed that its net cash position rose from £475 million at the end of the previous financial year to £1.1 billion. This suggests it has the financial means to not only overcome periods of potential economic or industry-related weakness, but also to invest in long-term growth opportunities.

Additionally, the company’s half-year results showed that its competitive position continues to improve. Operating profit margin rose by 510 basis points versus the same period of the previous year so that it stood at 19.1%. This suggests it is well placed to capitalise on an upbeat long-term outlook both for the global economy and industries in which it operates.

An encouraging outlook

Indeed, the prospects for defence and civil aerospace, which are the firm’s two largest divisions and together contribute 77% of its revenue, are highly encouraging. Elevated geopolitical risks, largely prompted by conflict in Ukraine, have contributed to a step change in attitudes towards defence spending among NATO members. While most NATO countries historically struggled to meet a target to spend 2% of GDP on defence each year, they will now aim to spend 5% of GDP on the military, with 3.5% being on core defence spending.

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When combined with an upbeat long-term outlook for the world economy, which should mean that GDP across NATO members rises, this could mean that defence firms experience significantly higher demand.

Similarly, the company’s civil aerospace segment has an upbeat long-term outlook. A period of modest inflation and further interest rate cuts could boost consumer spending power. This may lead to higher demand for discretionary items, such as those in the travel and leisure sector, with the International Air Transport Association (IATA) expecting global passenger numbers to rise by 5.8% in the current year. In turn, this could mean that demand for Rolls-Royce’s aeroplane engines, and their subsequent maintenance needs, increases.

With the firm being well placed to capitalise on other long-term growth trends, notably net zero via its small modular reactors, the company’s financial prospects are relatively upbeat. Indeed, it currently forecasts that it will post an 11% annualised rise in operating profits between 2024 and 2028.

Risk/reward ratio

Clearly, Rolls-Royce’s share price may not deliver the same scale of returns in future as it has done in the recent past. After all, its earnings multiple suggests investors have factored in a substantial part of the company’s upbeat future outlook.

But the firm’s solid balance sheet, improving competitive position and strong growth potential in its key segments suggest that it still offers a favourable risk/reward opportunity on a long-term view. Therefore, it would be unsurprising if further capital gains and index outperformance lie ahead.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.