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Rolls-Royce (LSE:RR) shares have continued to fly over the past year. They are up 50% over this period and have posted fresh record highs over the summer. At £15.37, some wonder if the stock is becoming overvalued and could suffer a fall in the next few months. I turned to my AI friend ChatGPT to see what the probability was that it could fall back below £10 by the end of the year.
Digesting the opinion
ChatGPT is very optimistic that this won’t happen. In fact, it puts the chances between 5% and 10%. It noted (correctly) that the hurdle for such a fall is quite large. Rolls-Royce shares would need to fall close to 35% from here to finish below £10.
In terms of reasoning, I believe that a move that large would probably require a genuine deterioration in the investment case rather than ordinary profit-taking. However, I have seen it in the past that selling can beget more selling, as people start to panic. This can make any drawdown in the share price quite sharp in the short term, before any potential recovery.
Adding in my view
Clearly, Rolls-Royce has strong momentum right now. It recently raised 2026 underlying operating-profit guidance to £4.7bn–£4.9bn after H1 operating profit rose 46% to £2.5bn. Free-cash-flow guidance was also lifted to £3.8bn–£4.0bn. In terms of specific areas, Civil Aerospace margins have improved sharply, defence demand remains strong, and Power Systems is benefiting from data-centre demand.
On that basis, I also struggle to see the stock falling below £10 by the end of the year. However, I’d put the chances higher than ChatGPT, and put it between 15% and 20%.
The reason my percentage is higher is the growing potential for earnings disappointment and valuation compression. To be clear, the business doesn’t necessarily have to collapse. But after such an extraordinary share price run over the past few years, it’s increasingly sensitive to anything that challenges the assumption that today’s very high profitability is sustainable.
For example, Rolls-Royce earns substantial aftermarket revenue from the Civil Aerospace division. Management has already been talking up how well it’s doing. Yet, if we see further geopolitical disruptions or deterioration in long-haul travel, this area could really take a hit and impact the overall group.
When I talk about valuation compression, it sounds technical but I’m just talking about the price-to-earnings (P/E) ratio falling. At the moment the valuation is high, as the P/E ratio of 52.04 denotes. Over time, I’d expect this to fall to closer to the FTSE average in the 10-20 region. One way this could happen is if earnings stay the same but the share price falls.
The bottom line
Putting it all together, I agree that the risk of a sharp fall with Rolls-Royce shares below £10 isn’t that high. However, I’m cautious about investing a big amount right now, as I think the pace of further appreciation is more limited. Investors could consider it, but might find better opportunities elsewhere.
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Jon Smith does not hold any positions in the companies mentioned.
This story originally appeared on Motley Fool
