Head to Head: ARM vs. Sage

LONDON -- In this series, some of your favorite FTSE 100 shares go head to head in a three-round contest for superiority.

In Round 1, the firms fight on earnings; in Round 2, on dividends; and Round 3 is a battle of the balance sheets. The winner will be the company that has racked up most points at the end of the contest.

Stepping into the ring today are microchip designer ARM Holdings  (LSE: ARM  ) and software firm Sage Group  (LSE: SGE  ) .

The shares of both companies have out-performed the FTSE 100 over the past six months. The Footsie is up 8%, but Sage is up 22% and ARM a whopping 54%.

Let's take our ringside seats.

Round 1: earnings

Metric 

ARM

Sage

Recent share price

741 pence

309 pence

Last year price-to-earnings (P/E)

59.5

14.8

Current year forecast P/E

51.2

15.5

4-year EPS compound annual growth rate

47%

11%

Current year forecast EPS growth

16

(5%)

Forecast operating margin

45%

26%

Sources: Digital Look and Morningstar. Winners in bold.

Sage comfortably takes the points for P/E but ARM is equally dominant in scoring on earnings growth. ARM edges the first round due to its superior operating margin.

Round 2: dividends

Metrid 

ARM

Sage

Last year dividend yield

0.5%

3.2%

Current year forecast dividend yield

0.6%

3.4%

4-year dividend CAGR

15%

9%

Current year forecast dividend growth

17%

7%

Forecast dividend cover

3.6

1.9

Sources: Digital Look and Morningstar. Winners in bold.

It's a similar story in Round 2. Sage takes the first two points comfortably but ARM hits back strongly with its growth numbers. Again the round is decided in ARM's favor on the final point, which, in this case, is more conservative dividend cover.

Round 3: balance sheet

Metric 

ARM

Sage

Price/book ratio

9.7

2.2

Net gearing

(3%)

1

Sources: Digital Look and Morningstar. Winners in bold.

It's one point apiece in Round 3. Sage takes the P/B point easily, while ARM edges the gearing point. ARM's negative number for gearing indicates net cash on the balance sheet, but Sage isn't far behind with virtually no debt.

At the end of the contest, ARM has won two rounds and one round has finished in a draw. The overall points tally is ARM seven and Sage five.

Post-match assessment
It's often the case in our series of head-to-head contests that one company does better on the valuation-ratio points -- historic and forecast P/E, historic and forecast dividend yield, and P/B -- while the other does better on the measures that aren't dependent on the current share price.

Today's contest has seen this in its most extreme form. Sage took all five of the "value" points -- and by a large margin in each case -- while ARM thoroughly dominated on earnings growth, dividend growth, margin and dividend cover, as well as taking the gearing point for being in the position of having net cash.

P/B isn't a particularly useful ratio for technology companies and dividends aren't typically a major draw for investors in this sector, though Sage's yield isn't bad. That leaves us with earnings.

Does ARM's high P/E but vastly superior earnings growth make the microchip designer better value than Sage? Or does Sage's lower P/E but lower earnings growth make the software company a better bet? Finally, even if one company is good value relative to the other, is it good value in an absolute sense?

Looking at P/E-to-earnings-growth is one way of answering these questions.

Company

Historic P/E

Historic EPS Growth

Forecast P/E

Forecast EPS Growth

Historic PEG

Forecast PEG

ARM

59.5

47

51.2

16

1.3

3.2

Sage

14.8

11

15.5

(5)

1.3

N/A

A PEG of 1 implies that earnings growth is fairly valued by the market. A PEG of less than 1 suggests the market may be undervaluing the earnings growth, while a PEG of more than 1 indicates a possible over-valuation.

As you can see, ARM and Sage have the same historic PEG of 1.3. However, ARM is infinitely superior to Sage on the current-year forecast PEG because Sage is expected to deliver negative earnings growth. That said, ARM's PEG rises to 3.2 this year because earnings growth is forecast to be below its historic level.

In summary, ARM is relatively good value compared with Sage on the PEG measure, but in absolute terms the market appears to be overvaluing ARM's forward earnings growth. However, that's not to say ARM's shares can't go higher still; indeed, they've jumped to 774 pence recently on rumors of a possible 1,200-pence-a-share cash bid from American giant Intel!

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