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Should You Sell ARM Holdings plc And Buy Imagination Technologies Group plc?

Despite announcing that it made a pre-tax loss of £10.7 million in the first half of the current financial year, shares in Imagination Tech (LSE: IMG) have surged by over 10% today. While it may seem rather perverse for a company to report that it has slipped back into a loss, only for its share price to rise strongly, the reason for the uplift in investor sentiment is the medium-term potential that Imagination Tech offers.

For example, the major reason for the loss is an increase in expenses that had previously been flagged up by the company. These costs include significant investment in intellectual property, which should allow Imagination Tech to enjoy higher margins due to a slower growing cost base over the medium term. In fact, it is targeting an operating margin of 30%-40% over the long term, which would clearly be great news for the company’s bottom line, as well as for shareholders.

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Growth Potential

Clearly, Imagination Tech has considerable potential. And, as today’s update shows, it is willing to take some short-term pain in order to make the necessary changes so it can deliver impressive growth over the medium term. In fact, Imagination Tech is forecast to post earnings growth of 39% next year, which would be hugely impressive and show that it remains a highly appealing growth play.

Valuation

Encouragingly, Imagination Tech continues to offer such strong growth prospects at a very reasonable price. Certainly, its price to earnings (P/E) ratio of 38.9 may put off a lot of value investors, but when its impressive growth prospects are taken into account, it equates to a price to earnings growth (PEG) ratio of just 1.

This indicates growth at a reasonable price and, in fact, seems more appealing than fellow technology stock ARM (LSE: ARM) (NASDAQ: ARMH.US). It has a PEG ratio of 1.5 and, on this basis, it would be understandable as to why investors would seek to sell ARM and buy Imagination Tech, since the latter offers higher growth forecasts at a lower price.

Looking Ahead

However, ARM still has huge appeal. For starters, it remains a top-notch growth play that is forecast to increase its bottom line by 14% in the current year, and by a further 22% next year. Although lower than Imagination Tech’s expected growth rate, ARM has a much more consistent track record when it comes to earnings growth, with it having risen in each of the last four years by an average of 41% per year.

This contrasts markedly with Imagination Tech, which has seen an increase in its bottom line in only two of the last four years, with earnings increasing by an average of 4% per annum during the period. As such, it seems to offer less consistency than ARM, which may explain why ARM trades on a premium valuation compared to Imagination Tech.

Of course, both stocks could be worth holding in 2015 and beyond and, while Imagination Tech does have a very bright future (especially with regard to an expansion of operating margins), ARM still has huge growth potential, too. Therefore, moving forward, the two companies could make for a potent pairing in Foolish portfolios.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings. The Motley Fool UK owns shares of Imagination Technologies. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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