ARM (LSE: ARM) (NASDAQ: ARMH.US) is a company that has a loyal band of followers because of the high quality nature of the business.
It leads where others follow and is at the centre of many of the intellectual property designs that are featured in everyday electronic items such as mobile phones.
Of course, the interesting facet of ARM is that its designs are generally viewed as adding a tremendous amount of value to the products in which they are used. Indeed, because ARM focuses on intellectual property design rather than manufacturing, it possesses a large amount of leverage over the companies it supplies because there are not a whole host of substitutes available.
In other words, ARM benefits from having unique products and, as such, from there being a lack of competition.
This feature means that the market is expecting a lot from ARM over the medium to long term, as technology becomes an ever greater part of our lives. Although this can be viewed as a positive in terms of large interest in the company and positive market sentiment pushing shares higher, it also means that some investors think there may be limited value left in the shares.
For instance, ARM currently trades on a price to sales ratio of 22.6. This is extremely high and, on its own, would indicate a lack of value in the shares at current price levels.
However, when expectations for revenue growth are taken into account, a price to sales ratio of 22.6 does not seem so absurdly high. Indeed, sales are expected to be 40% higher within two years than they are currently, putting ARM on a forward price to sales ratio of 16.
Furthermore, when the aforementioned high quality of ARM’s business is considered, such a high price to sales ratio may be entirely justified. In other words, the market may be looking at long term trends such as increased use of technology and, when coupled with the lack of substitutes available for ARM designs, it may be willing to bet that sales growth will continue at a very brisk pace in the long run.
In my view, there could still be upside of over 20% in ARM’s share price. This could occur simply through the current price to sales ratio remaining where it is, while sales increase by 20%. A lower price to sales rating and on-target sales growth over the next two years would have the same effect, meaning that ARM shareholders would not have to rely upon improved market sentiment to post high share price gains.
