In the span of less than a week, shares of Arm Holdings (ARM 0.58%) skyrocketed from $77 to nearly $149 as of Monday's close, almost doubling in value. The catalyst behind this strong movement was the company's earnings report and promising guidance.
While the results were good, were they really good enough to warrant this kind of move in Arm's valuation, or is this simply proof that there is a bubble when it comes to artificial intelligence (AI) stocks?
Arm's earnings were good, but profits actually declined by 52%
What really ignited shares of Arm last week were its third-quarter results, which covered the last three months of the year. The company's adjusted earnings per share (EPS) of $0.29 came in better than the $0.25 analysts were expecting. On the top line, revenue of $824 million was far higher than expectations of $761 million.
Those were good results, but here's why I wouldn't call them great.
NASDAQ: ARM
Key Data Points
For one, Arm's actual net income was $87 million, which was less than half of the $182 million it posted in the prior-year period. Its unadjusted EPS was only $0.08, and it got up to $0.29 due to adjustments related to share-based compensation, which totaled $196 million.
Share-based compensation is a real expense the company pays out in stock instead of through cash. If it's excluded from the adjusted earnings calculation, you can see how a company could manipulate its earnings to make them look good -- simply load up on share-based compensation, since those expenses will effectively disappear when going up against Wall Street's numbers. When you include share-based compensation, Arm's profits look far less impressive than the earnings beat might otherwise imply.
Secondly, the company's revenue grew by 14% compared with the prior-year period. That's good double-digit growth, but on a quarter-over-quarter basis, the top line only rose by 2%. For the fourth quarter, however, the company is projecting sales to come between $850 million and $900 million, which would result in a quarter-over-quarter jump of 6% (at the midpoint).
Arm's sales are growing, but revenue isn't exactly taking off due to demand for AI chips. While it is an industry leader in the chip design space, one of the early criticisms of the stock was that its growth rate hasn't been all that high, and that it could take a while for Arm to benefit from a surge in demand for AI chips.
Heading into earnings, the stock was also trading at a whopping 25 times revenue, and investors were paying a premium for a stock that wasn't generating strong revenue growth. Now, Arm's price-to-sales multiple is even higher, at more than 50. That's a higher premium than chipmaker Nvidia, whose stock trades at 41 times revenue.
Arm is the latest tech stock to reach a bloated valuation
Arm isn't the first tech stock to soar to an outrageous valuation. Since the start of 2023, Nvidia has risen roughly 400%. Social media company Meta Platforms, which was coming off a bad 2022 but has also been investing into AI of late, has soared by close to 300%. C3.ai, which provides AI solutions, has seen its valuation jump by 160% since the start of last year, even though its results haven't been all that impressive.
The surge in Arm's valuation is a bit more extreme, given how quickly it has ascended in price. Up until the end of January, Arm's stock price had only increased by 11% since it went public in September.
Investors are better off steering clear of Arm's stock
Given Arm's extremely expensive valuation, this isn't a stock I'd consider buying right now. The recent volatility surrounding the stock concerns me that this might have become a speculative buy and a way for people to bet on AI. Since Nvidia is already worth $1.8 trillion, investors may see Arm as the next stock to soar and potentially hit the $1 trillion mark.
But Arm's financials aren't nearly as strong as Nvidia's. And investors need to consider financials and fundamentals before buying shares of a company. Arm's numbers just aren't that impressive and don't justify this kind of premium on the business. It all does seem to suggest that a bubble around AI stocks may be forming, making them potentially risky stocks to buy at their current valuations.
Arm investors are paying for a lot of future growth, and that can be risky if things don't play out as expected. Instead of jumping on the bandwagon and taking on a risk with an extremely expensive stock in Arm, investors may be better off buying other tech stocks, which trade at much more reasonable valuations.
