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How ARM Holdings plc Could Struggle To Repeat A 5-Year Gain of 684%

The shares of British technology champion ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), currently trading at 860p, have soared 684% over the last five years, almost 12 times the 58% gain of the FTSE 100.

A repeat performance over the next five years looks a tall order, but ARM’s shares could still manage a triple-digit rise.

Here’s how

ARM is a global leader in semiconductor technology design. The company’s revenue comes from the initial licensing of designs, and then ongoing royalties. Key client relationships and market dominance make ARM a tough nut to crack for would-be rivals, as shown by a high and rising operating margin:

  Underlying operating
margin (%)
2014 (Q1) 50.4
2013 49.1
2012 45.6
2011 45.1
2010 40.4
2009 31.2

ARM’s high-performance, low-power technology is ubiquitous in smartphones, and pessimists can point to the increasing saturation of the smartphone market as a cause for concern. Optimists can point to the massive potential for ARM of the ‘Internet of Things’.

Indeed, ARM told us last month that 11 of 26 new licences signed in the first quarter of this year were for processors “for use in microcontrollers, smart sensors, and the Internet of Things and wearable technology”.

City analysts are forecasting that ARM’s earnings per share (EPS) will increase at a compound annual growth rate (CAGR) of over 15% from last year’s 20.9p to 42.8p by the year ending December 2018 — a total increase of 105%.

If the shares track earnings, and continue to rate on their current historic price-to-earnings (P/E) ratio of over 40, the price will of course rise by the same 105% as EPS, putting ARM’s shares at about 1,760p five years from now.

For ARM’s shares to repeat the same 684% gain as the last five years, the P/E would have to rise to a stratospheric 137. By contrast, for the shares to make no gain at all in the next five years, the P/E would have to fall to 20 — lower than the current rating of Unilever.

ARM has a habit of beating analysts’ forecasts, so I think there’s a fair chance of the shares making a high double-digit or low triple-digit gain over the next five years, even if the shares were to de-rate to a P/E of, say, 30-35.

Also, it’s worth bearing in mind that ARM has no debt, and that the cash on the balance sheet just keeps growing and growing. At the last reckoning it stood at £736m — equivalent to 52p a share, or two-and-a-half times latest annual EPS.

Finally, I can tell you that a cash-rich balance sheet and strong earnings prospects are qualities ARM shares with a hidden growth gem that's just been unearthed by the Motley Fool's leading small-cap analyst.

This £325m company is under the radar, and trades on a P/E three times lower than ARM's.

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G A Chester does not own any shares mentioned in this article. The Motley Fool owns shares in Unilever.