Play The Percentages With ARM Holdings plc

The forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.

However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).

EPS spread Bull extreme P/E Consensus P/E Bear extreme P/E
Narrow 10% (+ and – 5%) 13.3 14.0 14.7
Average 40% (+ and – 20%) 11.7 14.0 17.5
Wide 100% (+ and – 50%) 9.3 14.0 28.0

In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the consensus 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!

ARM Holdings

Today, I’m analysing Footsie tech giant ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), the data for which is summarised in the table below.

Share price 926p Forecast EPS +/- consensus P/E
Consensus 24.1p n/a 38.4
Bull extreme 27.2p +13% 34.0
Bear extreme 22.5p -7% 41.2

I was quite surprised to find that, with the most bullish EPS forecast 13% higher than the consensus, and the most bearish 7% lower, ARM’s 20% spread is half as narrow as the 40% spread of the average blue-chip company.

I mean, we’re talking about a high-growth tech company, yet analysts see plausible earnings scenarios in around as narrow a spread as such defensive stalwarts as drinks group Diageo (23%) and pharma firm GlaxoSmithKline (17%).

The answer is that ARM isn’t some flighty tech small cap, whose earnings ‘could be anything’. This is a highly cash-generative £13bn company. ARM is the world’s leading semiconductor technology designer, and has a stranglehold on mobile phones, in more than 95% of which ARM’s designs are used.

The visibility afforded by ARM’s business model is also helpful for analysts’ earnings projections. Basically, operational costs can be netted off against revenues from the new technologies that ARM licences, leaving relatively predictable ongoing royalty revenues as the basis for earnings forecasts.

Just because this revenue stream is relatively predictable, though, doesn’t mean to say it isn’t growing fast. It is! As the licensing base grows, royalty revenues gather momentum: we’ve seen a more than 10-fold increase over the past 10 years.

With its dominant market position, phenomenal history of earnings growth, and new opportunities in an ever-more connected world, ARM’s shares trade on an eye-watering P/E. I have to say, the narrowness of the EPS spread doesn’t help much when we’re talking about a consensus P/E of 38.4 — and the decimal point at this level becomes pretty ridiculous!

US tech investors may not bat an eyelid at buying on such P/E, but many of us in the UK balk at the idea. I know I do. The best I can offer anyone keen on the company is that the share price is getting on for £2 lower than investors were willing to pay at the turn of the year.

However, I can also tell you that within the less well-trawled sea of smaller companies, the Motley Fool's top analyst has just discovered a super growth opportunity on a fraction of the rating of ARM.

Indeed, our leading analyst believes this cash-rich company, which operates in an attractive growth market, is the best growth share for 2014.

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G A Chester does not own any shares mentioned in this article. The Motley Fool has recommended shares in GlaxoSmithKline.