Why Is ARM Holdings plc So Expensive?

Looking around the companies in the FSTE 100, a good many are clustered around the index’s long-term average price to earnings (P/E) ratio of 14. But compared to that benchmark, there are others that look very cheap, while some look a bit pricey.

ARM HoldingsUp near the top we have ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), the designer of those whizzy computer chips that power a large portion of the world’s phones, tablets, and other computing devices. Priced at 893p today, ARM shares are on a forward P/E of 38 based on 2104 forecasts.

50 billion!

More than 10 billion ARM-designed chips were shipped in 2013, taking the company’s total since 1993 to over 50 billion. And it’s not just iPhones and iPads that rely on ARM chips — the company is also continuing to make inroads into the server and networking markets, and all sorts of embedded processing applications like medical devices.

That has all fed through into rapidly-growing bottom-line profits. Back in 2009, ARM recorded earnings per share of 5.5p — an its shares ended that year on a P/E multiple of 33.

That 5.5p had climbed to 20.9p per share by last year — a 3.8-fold rise in earnings in just four years. Over that period, the share price has actually kept ahead of earnings too — it’s soared to a five-fold gain, ending 2013 on a trailing P/E of 53.

Has it gone too high?

But the big question — with the share price having risen faster than earnings, is the current valuation too cheap, too expensive, or would it be to the linking of Goldilocks. It has, after all, stagnated a little over the past 12 months, having gained only around 5%.

Well, the fall from a P/E of 53 last year to a forward multiple of 38 is down to a simple reason — earnings are expected to keep on rising. There’s a 14% gain on the cards for this year, and a prediction of a further 22% rise for 2015 would take the P/E down further, to 31.

And all the time, the annual dividend is rising. Sure, it’s set to yield only 0.8% this year. But if the shares were on a P/E of that average 14, the yield would be around 2.2% — that would still be short of the FTSE’s 3% average, but it does suggest that should the day come when ARM’s growth starts to slow, it will be well on the way to becoming a blue-chip provider of solid annual cash.

No, ARM is cheap

So, cheap or expensive? In my view, cheap, without a doubt. And the majority of brokers agree — of a 35-strong sample, 18 are putting out Buy recommendations with only three suggesting we should Sell.

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Alan does not own any shares in ARM Holdings. The Motley Fool has recommended shares in ARM Holdings.