The stock’s high valuation raises the risk of a post-earnings sell-off this week.
Arm Holdings (ARM 0.13%) has been a rising star in the semiconductor industry. Its technology is used in half of all chips and virtually every smartphone, including Apple‘s iPhone 16, according to reports. Shares have soared 141% since its initial public offering last year.
Arm’s lucrative business model based on licensing and royalty revenue makes it a solid business. However, while investors might be tempted to buy shares, the stock’s high valuation gives me pause. With another quarterly earnings report coming on Nov. 6, there is the potential for an earnings miss to send the stock down, and investors might be wondering if it makes sense to buy before the report on the second quarter of its 2025 fiscal year comes out.
Why invest in Arm
Arm is an outstanding business. Its fiscal first-quarter revenue accelerated 39% year over year, driven by record licensing revenue. The company signed several licensing agreements in the quarter. Alphabet‘s Google and Amazon Web Services are prominent cloud service providers using Arm-based chips in their data centers.
I love Arm’s business because it doesn’t have to invest massive amounts of capital in equipment and facilities for manufacturing chips. It designs chips and licenses its technology to other companies. Nvidia‘s Grace central processing units (CPUs) are based on Arm. After licensing, Arm earns royalty revenue on every chip shipped using its technology. This explains why Arm generates very high profit margins.
It’s a powerful business model with excellent growth prospects. The company is seeing growing adoption for its Armv9 chip design, most notably in data centers, cloud servers, and the automotive industry. Licensing revenue surged 72% year over year last quarter, and while this revenue can be lumpy quarter to quarter, it points to long-term growth in royalties. Arm says the time between signing a licensing deal and seeing those chips used in new products, which unlocks royalties, can take four years or longer.
With Arm-based chips starting to be used for artificial intelligence (AI) workloads in data centers and AI-powered devices, the company should see several years of robust growth in revenue and earnings.
Wait for a better price to buy shares
The only negative with Arm is the stock’s lofty valuation. The shares trade at a forward price-to-earnings (P/E) ratio of 98. Normally, I like to buy growth stocks when their forward P/E is closer to the company’s underlying growth in earnings. Analysts expect earnings to increase by 22% for the company’s March-ending fiscal year before increasing by 32% the following year, according to Yahoo! Finance.
Moreover, analysts are forecasting fiscal Q2 earnings to be down 31% year over year to $0.25. Revenue is also expected to increase by just 8% over the year-ago quarter. This is a normal fluctuation in Arm’s business, but it does add to the risk that investors may not see enough growth to justify a high valuation, which could send the stock down after the upcoming earnings report.
I would like to see more growth before paying such a high forward P/E multiple for the shares, especially when there are other leading semiconductor companies also benefiting from AI demand but offering a more attractive balance of growth and value.
Investors should keep Arm shares on their watch list and consider buying on a pullback.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. John Ballard has positions in Nvidia. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, and Nvidia. The Motley Fool has a disclosure policy.
