Here’s Why ARM Holdings plc Could Fall 64%

There is no doubt that ARM (LSE: ARM) (NASDAQ: ARMH.US) is a high-flying tech stock. However, the company’s shares are expensive.

In particular, ARM is currently trading at a lofty historic P/E of 44 and a forward P/E of 38. Further, the company is trading at a PEG ratio of 2.7, implying that the stock is expensive for the growth it is expected to generate.

Unfortunately, this high valuation leaves little room for disappointment and investors could see the value of their holdings fall by up to 64% if the company fails to meet City targets.

Starting to slowARM Holdings

But ARM’s performance is already starting to slow and some are starting to questions the company’s sky-high valuation. Indeed, the company’s total first-quarter dollar revenues rose by 16% compared to year-ago figures, although this rate of growth was less than the 26% rise reported during the first quarter of 2013.

Total first quarter dollar revenues rose by 16% year-over-year or 10% in sterling terms. This compares with a 26% dollar and 28% sterling rise for the first quarter of 2013.

Still, ARM’s management had already warned that the first quarter would be slower than usual, as slower sales of chips for high-end smartphones would drag on performance. 

Nevertheless, ARM’s sales are likely to slow over the longer term as, the larger the company becomes, the harder it will become for management to find growth opportunities. 

Not all bad news

Having said all of the above, ARM’s first quarter update contained some good news. The group’s management remained upbeat about the rest of the year and revealed that outlook for the semiconductor industry should improve during the second quarter.

With this being the case, ARM expects the company’s performance this year to be in line with City expectations.

How low can it go?

The question is, if ARM fails to meet City expectations, how far will the company’s shares fall? Well, ARM’s main peer, Intel currently trades at a forward P/E of 13.7, if ARM fell to this level it shares would be worth, 326p; a 64% slump from current levels.

However, ARM’s earnings are is still growing rapidly, while Intel’s growth is slowing (mainly due to ARM’s dominance within the sector). With this in mind, it doesn’t really make sense to compare the two companies.

Nevertheless, it is possible to place a valuation on ARM based on the company’s prospective growth. For example, the PEG ratio is used to establish whether or not a stock is priced appropriately based on the company’s rate of growth. A PEG of less than one implies growth at a reasonable price. A ratio above one implies that the company is expensive, based on its predicted growth rate.  

So, based on the fact that ARM’s earnings per share are expected to expand 14% this year, if ARM’s valuation fell to a PEG of one, indicating that growth was priced in, the company would trade at a P/E of 14. A P/E of 14 implies a share price of 333p; a fall of around 63% from current levels. 

A great growth story 

Arm has been one of the UK's greatest growth stories of the past decade. However, much of the company's growth is now behind it.

But there are other opportunities out there. The key, when searching for growth stocks, is looking under the radar. You want to get on board while the company is still an unknown quantity.

Analysts here at the Motley Fool have identified a share that we believe has the potential to nearly double profits within the next four years. So, if you're a keen growth investor looking for ideas, download this exclusive report entitled "The Motley Fool's Top Growth Stock For 2014".

The report is completely free, but you've only got a limited time to claim your copy. To claim before it's gone -- click here today -- it's free.

Rupert does not own any share mentioned within this article. The Motley Fool has recommended shares in Arm Holdings.