Arm Holdings(NASDAQ: ARM) is a key player in the global semiconductor industry. It designs, develops, and licenses its intellectual property (IP) to major chipmakers and original equipment manufacturers (OEMs), who then use the British company’s IP to create central processing units (CPUs) and other products, such as graphics processing units (GPUs) and neural processing units (NPUs).
The good part is that Arm’s critical position in the semiconductor market led to impressive gains since it went public in September 2023. Arm stock gained 144% since its U.S. stock market debut, though there have been ups and downs during this journey owing to its rich valuation.
Arm remains an expensive stock, with a trailing price-to-earnings ratio of 297. The forward earnings multiple of 90, however, points toward a nice surge in its bottom line. Does this mean investors looking for a growth stock should consider buying Arm despite its expensive trailing earnings multiple in the hope that a terrific jump in its bottom line will help it justify its valuation?
We will take a closer look at Arm’s potential catalysts and consider whether buying this expensive semiconductor stock could turn out to be a good move for the long haul.
Arm licenses its IP to customers for a fee, generating up-front licensing revenue. It also gets royalty revenue from customers for each chip manufactured using its IP. With two sources of revenue, the company’s royalties forecasts a solid revenue stream.
The good news for Arm investors is that its licensing and royalty revenues could get a major boost following President Donald Trump’s announcement of a $100 billion investment in artificial intelligence (AI) infrastructure in the U.S. through a joint venture of SoftBank, OpenAI, Oracle, and United Arab Emirates-based AI investment vehicle MGX. These four companies are set to provide the initial funding for this joint venture, called Stargate, and aim to increase their spending to $500 billion over the next four years.
A post by OpenAI announcing the joint venture indicates that Arm is one of the “key initial technology partners” that will collaborate on this project. This is great news for Arm investors, as Stargate already started building its first data center in Texas. The venture plans to build a total of 20 data centers as part of the initial $100 billion investment reportedly being deployed immediately.
This massive projected spending on U.S. AI infrastructure bodes well for Arm as the company has been witnessing solid growth in demand for its latest AI-optimized chip architecture, Armv9. Smartphone makers are already using its Armv9 CPU architecture to make processors for mobile devices, driving solid growth in the company’s royalty revenue despite a tepid smartphone market.
For example, Arm’s smartphone royalty revenue increased 40% year over year in the second quarter of fiscal 2025 (which ended on Sept. 30, 2024), outpacing the “mid-single-digit increase in the number of smartphones sold, mainly due to smartphone application processors being increasingly Armv9-based with a higher royalty rate.”
Armv9 accounted for 25% of the company’s royalty revenue in the last reported quarter, up from 10% in the year-ago period. Looking ahead, the demand for Armv9 could keep getting better. CFO Jason Child said on the November 2024 earnings conference call that the company is gaining “share in automotive applications and with cloud service providers.”
More specifically, the share of Arm’s architecture in cloud computing increased to 15% in fiscal 2024 from 9% in fiscal 2022. Its share of networking equipment increased to 28% from 23% during the same period. That’s not surprising as the likes of Alphabet and Nvidia are designing server CPUs based on Arm architecture for handling AI workloads in data centers.
In April last year, Alphabet announced the arrival of an Axion custom server processor built on Armv9. The tech giant pointed out that Axion is capable of handling not only general-purpose workloads in servers but also AI model training and inferencing. These custom AI processors built using Arm architecture are already available to Google Cloud customers.
Meanwhile, Arm’s architecture is also powering Nvidia’s Grace server CPU, which is being deployed in AI systems and supercomputers. So, Arm’s AI-specific chip architecture should ideally witness a sharp jump in adoption and help the company strike more licensing deals and increase its royalty revenue, thanks to the huge investment in AI infrastructure announced at the White House.
But will Arm’s expensive valuation allow it to deliver more gains in the next five years?
We already saw that Arm’s latest AI-focused Armv9 architecture drives outstanding revenue growth for the company despite much lower shipments due to a higher royalty rate. This is also probably the reason Arm’s profit margin started heading higher in the past year.
The company’s improving margin profile positively impacts its bottom line. Consensus estimates are projecting a 23% improvement in Arm’s earnings per share in the current fiscal year to $1.56 per share. This is expected to be followed by stronger growth in the next couple of fiscal years.
So, Arm’s earnings are expected to show a compound annual growth rate of 28% from fiscal 2024 to fiscal 2027 (using fiscal 2023 earnings of $1.27 per share as the base). Assuming Arm could see even a 25% earnings growth rate in the two years following fiscal 2027, its bottom line could hit $4.19 per share after five years. Of course, that estimate could be conservative if we consider that the higher royalties of Armv9 could help it generate stronger earnings growth beyond the next three fiscal years.
But even if Arm’s bottom line hits $4.19 per share after five years and the stock trades at 50 times earnings at that time (in line with the U.S. technology sector’s average price-to-earnings ratio and at a much lower level than its forward earnings multiple of 78), its stock price could hit $210. That would be a 28% increase from current levels. However, don’t be surprised to see the stock delivering more upside, as it seems capable of growing at a much more aggressive pace.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Nvidia, and Oracle. The Motley Fool has a disclosure policy.
