Are ARM Holdings plc And Diageo plc Really Worth The Premium?

Today I’m considering the investment case for two FTSE 100 giants boasting expensive ‘paper’ valuations.

A tad heady?

At face value drinks leviathan Diageo (LSE: DGE) can hardly be considered attractive value for money. Thanks to a predicted 1% earnings decline in the year to June, the business currently changes hands on a P/E rating of 21.9 times.

This clearly sails some way above the benchmark of 15 times that indicates ‘conventionally’ reasonable value for money. And Diageo’s earnings multiple remains elevated at 20.2 times for fiscal 2017 despite expectations of a 9% bottom-line uptick.

Investors can’t rely on chunky dividend flows through this period to compensate for Diageo’s inadequate P/E ratios either. Sure, it’s expected to keep dividends rolling higher, medium term, but yields of 3% and 3.2% for this year and next still lag the FTSE 100 average of around 3.5%.

Brand beauty

But Diageo has long trailed most of its blue-chip peers value-wise, and with good reason. Not all stocks are equal regardless of paper projections and investors are willing to pay a bit extra for quality stocks like Diageo.

The market places large importance on Diageo’s portfolio of industry-leading labels like Guinness, Smirnoff and Captain Morgan. These command terrific consumer loyalty like few others, providing investors with confidence that Diageo can keep lifting prices regardless of wider economic pressures. In the current climate, stocks that can boast such brand power can’t be underestimated.

That’s not to say Diageo is without its share of problems as the company battles currency movements and the prospect of fresh sales weakness in emerging markets.

But the firm’s share price still galloped higher in recent months. The market believes Diageo’s expansion into the ‘premium’ segment provides terrific sales opportunities. Furthermore, its expansion across Latin America and Asia is predicted to underpin robust revenues growth as disposable incomes in these geographies march higher.

Share price star

Chipbuilder ARM Holdings (LSE: ARM) has also been unpopular with bargain hunters fixated on near-term valuations. However, those simply snapping up stocks with attractive paper valuations would have missed out big time by overlooking the company.

Someone who had bought it a decade ago would now be celebrating the 600%-plus share price ascent chalked-up to date.

Back to the future

Of course investors today will give scant regard to the company’s previous performance, particularly as its explosive growth story was underpinned by rapid growth in smartphone and tablet PC demand, a phenomenon now receding.

But that’s not to say ARM’s hot growth is drawing to a close. Far from it. The Square Mile expects earnings expansion of 44% and 13% in 2016 and 2017, respectively.

Subsequent P/E ratings of 28.7 times and 25.4 times may — like those at Diageo — appear heady. And dividend yields of 1% for 2016 and 1.2% for next year are hardly exciting either.

But I believe ARM Holdings’ key qualities fully merit such a premium. The company enjoys top-tier supplier status with mobile giants like Apple and Samsung, while its cutting-edge technologies continue to grab market share from competitors. And ARM Holdings is also enjoying accelerating success in new markets like networks, servers and the Internet of Things.

The tech play saw pre-tax profits surge 14% to £137.5m during January-March, it said Wednesday, as the number of chips shipped rocketed 10% to over 4.1m units.

I believe ARM Holdings has what it takes to keep earnings galloping higher and its share price rocketing, putting paid to its reputation as an ‘expensive’ stock selection.

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