ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) investors have seen the value of their shares slide by 16% so far in 2014, but the firm’s share price is still 650% higher than it was five years ago.
Does ARM’s current share price offer new investors a decent chance of a profit, or is the firm’s valuation better suited to investors wanting to take profits?
Valuation
Let’s start with the basics: how is ARM valued against its historical and forecast performance?
| P/E ratio | Current value |
| P/E using 5-year average adjusted earnings per share | 73.6 |
| 2-year average forecast P/E | 35.5 |
Source: Company reports, consensus forecasts
ARM’s trailing 5-year average P/E of 73.6 is a reflection of its rapid growth: over the last five years, the firm’s adjusted earnings per share have risen from 5.5p to 20.6p.
Looking ahead, current forecasts give ARM a two-year average forecast P/E of 35.5. In part, this reflects the fact that ARM’s profits are still rising fast, but it looks expensive to me.
Here’s why
ARM’s adjusted earnings have risen by an average of 30% per year over the last five years. If this rate of growth continues for another three years, ARM’s adjusted earnings will be about 46p per share. At today’s share price of 920p, that would still equate to a P/E of 20.
In my view, ARM’s medium-term growth is already in the share price — the only way in which new buyers today could see significant profits would be if ARM was taken over by a large manufacturer, such as Apple, Intel or Samsung.
What about the fundamentals?
There’s no doubt that ARM has delivered strong, consistent growth over the last five years:
| 5-year compound average growth rate | ARM Holdings |
| Sales | +18% |
| Pre-tax profit | +30% |
| Adjusted earnings per share | +30% |
| Dividend | +19% |
| Net cash | +33% |
Source: Company reports
In my view, shareholders might want to question why ARM’s dividend has only risen by an average of 19% per year over the last five years, while its net cash pile has risen by 33% per year during the same period.
For example, ARM added £201m to its cash pile last year, but only declared dividends worth around £80m.
ARM’s £588m net cash balance is now equivalent to around 80% of one year’s revenues: I believe the firm should be a little more generous with shareholder returns, unless it is planning a major acquisition, which seems unlikely.
Buy, sell or hold?
In my view, ARM remains a sell for growth investors, and a hold for early investors who are enjoying a decent dividend yield on cost.
I suspect ARM’s share price will continue to drift lower over the next year, and don’t see any reason to buy the shares today.