2025 has been a perfect storm for Rolls-Royce (LSE:RR.) shares.
At the start of the year, operational outperformance saw profit and free cash flow guidance for 2025 swell. By June, the British government selected Rolls-Royce to build the country’s first small modular nuclear reactors (SMRs). Then, between July and August, defence spending tailwinds picked up with new military contracts getting signed.
Skip ahead to October, global flight hours across the civil aerospace sector continued to trickle upward. And to top things off, management has just recently announced another round of share buybacks totalling £200m.
Suddenly, the FTSE stocks’ near 90% share price surge in 2025 makes a lot of sense. And shareholders are undoubtedly celebrating this success.
However, I’ve spotted something troubling. And if my hunch is right, Rolls-Royce shares might struggle in 2026. They could even crash by double-digits.
What’s on the horizon?
Before diving into the looming risks, some context is needed about Rolls-Royce’s trajectory in 2026.
As things stand, the business is actually on track to continue growing profits and cash flows next year. Defence spending across Europe is still ramping up, with the UK in particular aiming to expand its defence budget to 2.5% of GDP by 2027.
At the same time, lower interest rates are sparking increased activity for fleet renewal and upgrades among the civil aerospace sector, driving up demand for Rolls-Royce’s Trent engines. And around August 2026, the Generic Design Assessment (GDA) for the group’s SMRs is anticipated to be completed – a critical step towards reaching commercial production as well as getting more attention from the private sector, particularly data centre operators.
Needless to say, that’s all rather positive, so what’s the problem?
An overlooked challenge
At a market cap of £93bn, Rolls-Royce shares are trading at a forward price-to-earnings ratio of 35. And that’s a significant premium compared to the industry average of 25.8.
Seeing Rolls-Royce shares trade at a premium valuation is hardly a surprise given the quality of this newly restructured business. But it also exposes its share price to significantly greater risk of volatility if it starts to fall short of its lofty expectations. And on that front, there are several concerning points of failure.
Perhaps the most problematic is the state of its supply chains. Geopolitical disruptions and trade disputes have created enormous headaches for management, costing £382m in 2024 alone.
These challenges have only been exacerbated by the continued global shortage in titanium and speciality electronics. And if the situation worsens, Rolls-Royce might struggle to keep up with its order book.
Meanwhile, the growing risk of a recession in the UK and the US doesn’t bode well for transatlantic flights next year. If consumers pull back on travel spending, the recent gains in long-haul travel spending could unwind, lowering demand for Rolls-Royce’s engine maintenance and aftermarket services.
These are, of course, short-term challenges. But even a temporary delay can trigger a sell-off when investor expectations are high.
That’s why, despite my admiration for this business, the risk-to-reward ratio for Rolls-Royce shares no longer looks favourable in my eyes. And that’s why I’m looking at other 2026 opportunities for my ISA portfolio.
