This P/E Suggests ARM Holdings Is a Sell

LONDON -- The FTSE 100 has risen by nearly 18% over the last six months, and many top shares are beginning to look quite expensive.

I'm on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I'm using a special version of the price-to-earnings ratio called the PE10, which is one of my favorite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last 10 years, allowing you to see whether a company looks cheap, compared to its long-term earnings.

Today, I'm going to take a look at the PE10 for the smartphone chip maker ARM Holdings (ARM) (ARMH).

Is ARM a buy?
There's no doubt that ARM Holdings is an incredible success story, both as a company and as an investment.

To show you what I mean, let's take a look at ARM's current price-to-earnings ratio, and its PE10:

ARM's P/E of 68 is ambitious, but the company's long-term PE10 of 218 is just plain crazy.

Critics of the PE10 will say that it isn't suited to growth companies, but I don't agree. Can ARM really be worth 218 times its average earnings from the last 10 years?

Is ARM's growth about to slow?
Since 2009, ARM's share price has risen by 1,000%, and its earnings per share have quadrupled.

ARM's chip designs have dominated the smartphone and table markets, but average selling prices for these devices are now falling, and Intel's mobile offerings are beginning to gain market share.

ARM's chief executive, Warren East, is retiring in July, and I think that this will coincide with a slowdown in the company's growth rate.

What next for ARM?
ARM's profit margins per chip have fallen steadily in recent years, and most of its recent growth has been due to rises in volume, not profitability.

The firm's big hopes for growth are the Intel-dominated server market, and "connected devices" -- everyday devices like watches, which may soon be connected to the Internet.

I'm not convinced.

Sell ARM
In my view, ARM's share price does not accurately reflect the company's ability to deliver increased earnings.

I think a period of consolidation is long overdue, and the markets seem to agree -- after doubling in the last year, ARM's share price is down 9% so far this week.

Can you beat the market?
If you already own shares in ARM, then I'd strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top U.K. fund manager Neil Woodford's eight largest holdings.

Woodford's track record is impressive: if you'd invested 10,000 pounds into his High Income fund in 1988, it would have been worth 193,000 pounds at the end of 2012 -- a 1,830% increase!

This special report is completely free, but availability is limited, so click here to download your copy immediately.