Arm Holdings (ARM -6.14%) spooked investors this week by declining to offer an outlook for fiscal 2026, which kicked off in April, along with its quarterly report. Arm cited uncertainty surrounding U.S. tariff policy for the cautious stance.

Arm's intellectual property and technology are pervasive across the semiconductor industry. Arm-based chips reign supreme in the smartphone, microcontroller, and embedded markets, and they're making inroads in PCs and servers as well. The explosion in artificial intelligence (AI) infrastructure spending is a boon, and increasing chip complexity, coupled with rising demand for custom chips, is pushing up royalty rates.

While Arm has plenty of visibility into its licensing pipeline, the company can't predict end-market demand. Arm earns royalties for each device shipped that uses its technology, so the volume of Arm-powered devices is the main driver of royalty revenue. Arm generates higher royalties for more complex chips, like server CPUs, and lower royalties for simpler chips like microcontrollers.

With Arm's outlook uncertain and the stock well off its all-time high, should investors buy the dip or stay away?

Image source: Getty Images.

The worst-case scenario is ugly for Arm

The smartphone market is critical for Arm. An Arm-powered chip is at the heart of essentially every iPhone and Android device that ships. In 2024, IDC estimates that global smartphone shipments grew 6.4% to 1.24 billion.

While smartphones are currently exempt from the worst of the U.S. tariffs on Chinese imports, the situation could change at any time. As it stands today, Apple expects tariffs to add around $900 million in costs in the current quarter, even as the company races to use non-Chinese manufacturing partners to source U.S.-bound iPhones. Smartphone prices in the U.S. could rise if Apple and its competitors pass off those higher costs to consumers, and they could rise further if a higher tariff rate is eventually put in place.

More expensive smartphones would likely knock down demand, leading consumers to hold on to their old phones for longer. If smartphone prices were rising in a vacuum, the hit to Arm would be small. Unfortunately, that's not the case. The prices of a wide range of products are likely to rise in the U.S. under the current tariff regime, and prices will spike further if the delayed reciprocal tariffs are allowed to go into effect.

While the timing and severity are up in the air, a recession in the U.S. is a real possibility. Downturns or recessions in other global economies, triggered by a drop in exports to the U.S., are a possibility as well. Weakness in the smartphone market could extend well beyond the U.S. if the impact of tariffs cascades in such a manner.

Outside of smartphones, Arm's push into PCs and servers could be stunted by slumping demand. The PC market would likely take a similar hit as the smartphone market under the worst-case scenario, with prices rising and end users holding on to devices for longer. In the server market, any slowdown in data center investment activity would hurt Arm's effort to grow its server CPU business.

Valuation is also a problem

In the long run, Arm will almost certainly remain dominant in its core markets and continue to gain ground elsewhere. In the short run, though, the company's results are anyone's guess.

One reason investors should be cautious, outside of the unprecedented level of uncertainty created by U.S. tariff policy, is Arm's valuation. The company is valued at around $125 billion, which puts the price-to-earnings ratio based on fiscal 2025 adjusted EPS well over 200. That's optimistic, to say the least.

While Arm's long-term growth story is still intact, the risks from U.S. tariffs, combined with a beyond-premium valuation, make the stock a risky bet.