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Does ARM Holdings plc Pass My Triple Yield Test?

Like most private investors, I drip-feed money from my earnings into my investment account each month. To stay fully invested, I need to make regular purchases, regardless of the market’s latest gyrations.

However, the FTSE 100 is up 68% on its March 2009 low, and the wider market is no longer cheap — it’s getting harder to find shares that meet my criteria for affordability.

In this article, I’m going to run my investing eye over ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), to see if it might fit the bill.

The triple yield test

Today’s low cash saving and government bond rates mean that shares have become some of the most attractive income-bearing investments available.

To gauge the affordability of a share for my income portfolio, I like to look at three key trailing yield figures — the dividend, earnings and free cash flow yields. I call this my triple yield test:

ARM Holdings Value
Current share price 865p
Dividend yield 0.7%
Earnings yield 2.4%
Free cash flow yield 2.1%
FTSE 100 average dividend yield 3.0%
FTSE 100 earnings yield 6.0%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.7%

A share’s earnings yield is simply the inverse of its P/E ratio, and makes it easier to compare a company’s earnings with its dividend yield. ARM’s earnings yield of 2.4% reflects its P/E rating of 41 — despite the 21% fall in the firm’s share price so far this year, it is still a very expensive stock.

As you’d expect from such a highly rated stock, ARM’s dividend yield is negligible, although its free cash flow yield of 2.1% (including money placed on deposit) suggests that the firm could afford much larger dividend payouts, especially as it has no debt, and net cash and short-term deposits of £587m.

Is ARM a buy?

In my view, ARM fails my triple yield test, as although its dividend is generously covered by free cash flow, the firm’s dividend and earnings yields are far too low to be of interest to me.

Although growth investors might say that ARM offers the potential for big capital gains, I think that this ship has already sailed; ARM’s share price fell by 6% yesterday, despite the firm reporting a 32% increase in pre-tax profits. This kind of behaviour is a classic symptom of a stock that is going ex-growth, and entering a period of re-rating and consolidation.

I reckon ARM’s share price will continue to drift lower for some time, as investors adjust to the idea that a £13bn company with pre-tax profits of just £364m might already have reached its optimum size.

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> Roland does not own shares in ARM Holdings.