Sector Screener: why Rolls-Royce shares still appeal

Source: Rolls-Royce via Flickr.

While the FTSE 350 index has enjoyed a “purple patch” over recent months, the Aerospace & Defence sector has vastly outperformed it. Over the past year, for example, the sector is up 91% versus a 20% rise for the wider stock market, benefiting from a variety of positive catalysts.

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Notably, elevated geopolitical risks have bolstered the long-term outlook for defence stocks. Conflicts in Ukraine and the Middle East have prompted governments across major developed economies to vastly increase their defence spending.

NATO members, for example, typically struggled to meet a longstanding target to spend 2% of GDP on defence, with just seven out of 30 countries doing so in 2022. Not only are all members expected to have met the target in 2025, they recently agreed to raise it to 5% by 2035. This should provide a significant and sustained improvement in the operating environment for FTSE 350 defence stocks, thereby increasing their profit growth potential over the coming years.

Additionally, the Aerospace & Defence sector has benefited from an improving global economic outlook. Although the prospect of tariffs has caused periods of intense economic uncertainty, inflation has moderated in recent months. This has allowed central banks to further reduce interest rates, thereby prompting improved prospects for GDP growth.

Given that military spending is expressed as a percentage of GDP, the prospect of a faster-growing global economy has bolstered investor sentiment towards defence stocks. Similarly, lower inflation and a stronger economy should lead to an improved consumer environment. This has prompted stronger market sentiment towards civil aerospace firms, with demand for their products set to rise in tandem with growing consumer spending on global travel.

An upbeat outlook

Prospects for the FTSE 350 Aerospace & Defence sector appear to be encouraging. Recent economic trends, in terms of falling inflation, interest rate cuts and improving economies look set to continue over the medium term.

For example, US and UK inflation rates are both expected to trend lower from their current above-target levels. In the US, for instance, the Federal Reserve expects inflation to fall so that it averages 2.4% this year and 2.1% next year. The Bank of England, meanwhile, anticipates that inflation will move closer to its 2% target during the second quarter of this year.

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Falling inflation should provide scope for further monetary policy easing. With the full impact of recent interest rate cuts in both the US and UK, as well as in the eurozone, not yet having been felt due to the existence of time lags, the performance of the world economy could improve further. This may act as an ongoing catalyst for civil aerospace firms, given that it is likely to mean consumer spending on discretionary items, such as air travel, rises. Similarly, defence firms should benefit from improved GDP growth as it equates to higher military spending overall.

Separately, attitudes among NATO members towards defence spending appear to have undergone a fundamental shift that seems likely to persist over the long run. As a result, it would be unsurprising if defence stocks experience a prolonged buoyant period as a higher priority assigned to military spending gradually translates into a stronger operating environment for industry incumbents.

Source ShareScope. Data at 19 January 2026. Past performance is not a guide to future performance.

Source ShareScope. Data at 19 January 2026. Past performance is not a guide to future performance.

Potential threats

Clearly, the Aerospace & Defence sector’s exceptional recent performance means that several of its members now trade on high market valuations. This may mean that they offer more limited scope for capital gains, given that there is unlikely to be significant upward rerating potential on offer. In some cases, moreover, they may now be trading in excess of their intrinsic value, which could equate to a disappointing investment return.

As a result, it is prudent to continue to focus on company valuations even as the sector appears to now offer a significantly improved long-term outlook than it did previously. By focusing on companies that appear to offer fair value for money given their fundamentals and growth outlook, investors may be able to prioritise those firms that have relatively favourable risk/reward ratios.

Source ShareScope. Data at 19 January 2026. Past performance is not a guide to future performance.

Rolls-Royce

Rolls-Royce’s share price has surged 116% higher over the past year. This is 25 percentage points ahead of the wider Aerospace & Defence sector’s rise, with the company’s shares now trading on a forward price/earnings (PE) ratio of 44.2. This figure is clearly exceptionally high, especially at a time when the FTSE 350 index has an earnings multiple of 18.7, and suggests there is now limited scope for an upward rerating.

The company’s financial performance, however, is set to improve. It is on track to deliver operating profits of around £3.75 billion in the 2028 financial year. If met, this would represent an 11% annualised growth rate versus its latest full-year results in 2024. A double-digit annualised rise in profits is likely to outperform that of the wider FTSE 350 over the coming years and suggests that the company may be worthy of a relatively high market valuation.

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Furthermore, Rolls-Royce Holdings (LSE:RR.)’s financial position has improved significantly over recent years. Having stood at £5.16 billion in 2021, the company’s net debt has fallen rapidly so that it had a net cash position of £1.08 billion at the time of its half-year results last June. This provides it with a stronger foundation through which to invest not only in its civil aerospace and defence segments, but also in other areas including battery energy storage and small modular reactors that could experience growing demand as the world continues its push towards net zero.

Clearly, the company’s shares could derate from their current high level. Indeed, a rich rating means they may be relatively susceptible to potential changes in the outlook for the wider Aerospace & Defence sector. But with a strong and improving financial position, an attractive earnings growth outlook and an upbeat operating environment, Rolls-Royce appears to offer an appealing risk/reward opportunity on a long-term view.

Chemring

Fellow Aerospace & Defence sector member Chemring Group (LSE:CHG)’s shares have risen by 63% over the past year. This represents a 28-percentage point underperformance versus the wider sector, with the firm’s latest annual results highlighting a relatively lacklustre growth rate in sales and earnings. Indeed, the company’s top and bottom lines rose by 3% and 4%, respectively, versus the previous year.

This rate of growth, though, is forecast to give way to a faster pace of increase. Over the next two financial years, for example, the company is expected to produce an annualised rise in earnings per share of 15%. Looking further ahead, the firm’s latest annual results stated that it is still aiming to double annual revenue in the five years to 2030. This suggests that further double-digit bottom-line growth could realistically be achieved over the long term.

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Following Chemring’s share price rise, it now trades on an earnings multiple of 27. While this is substantially lower than the PE ratios of several of its sector peers, it is nevertheless more than 40% higher than that of the wider FTSE 350 index. This suggests there may be limited scope for an upward rerating, as well as a heightened risk of share price volatility should the outlook for the defence industry become increasingly uncertain.

The company, though, appears to be financially sound. It has a net debt-to-equity ratio of 23%, while net interest costs were covered 12.9 times by operating profits in its latest financial year. When combined with its double-digit earnings growth prospects, as well as an upbeat overall outlook for the defence sector, this suggests the stock could deliver further capital gains over the coming years.

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