With shares up by 83% year to date, Arm Holdings (ARM 4.11%) enjoyed explosive stock price growth based on artificial intelligence (AI)-related optimism, which could boost sales for its intellectual property licensing business. But despite the hype, the company's valuation has become uncomfortably high. Let's discuss what the next five years could have in store for this booming stock.
What is Arm Holdings?
Founded in 1990, the U.K.-based Arm Holdings is a technology company that develops and licenses intellectual property for designing central processing units (CPUs), a core component in computers, smartphones, and other electronics. After an initial public offering (IPO) in late 2023, it enjoyed a surge of interest because investors expect it to benefit from rising hardware spending as businesses scramble to handle increasingly complex AI workloads.
That said, ARM's third-quarter earnings do not show rapid AI-led transformation. Revenue grew by a modest 14% year over year to $824 million. To put that number in context, chipmaker Nvidia saw its revenue soar 265% year over year to $22.1 billion in its most recently reported quarter. These figures are not even in the same ballpark, and there could be several reasons for the discrepancy.
Why is Arm underperforming Nvidia?
While Arm Holdings and Nvidia are both billed as "AI companies," there are significant differences between their business models. Nvidia specializes in graphics processing units (GPUs). These chips excel at performing multiple tasks simultaneously, making them ideal for computationally demanding workloads like running and training AI algorithms. On the other hand, Arm focuses on CPUs, which are less ideal for this use case.
Image source: Getty Images.
Furthermore, Arm doesn't manufacture or sell these CPUs directly. Instead, it focuses on developing intellectual property and designs. To be fair, Arm-based IP is popular -- powering 99% of all premium smartphones, according to the company website. But despite the widespread use, Arm may have limited pricing power. If it jacks up licensing fees too much, it could lose market share to rivals like Intel, which develops competing IP.
To make matters worse, many of Arm's core markets, such as smartphones, seem to have peaked around 2018 and are now in decline as people delay phone replacement and keep their devices longer. It is unclear if Arm's yet-to-materialize AI boom can make up for this secular decline in what has historically been its biggest growth driver.
What will the coming years have in store?
After its meteoric rise this year and last year, Arm Holdings stock looks painfully over-valued, especially considering there isn't much evidence of an AI-driven boom in its revenue and earnings. With a price-to-earnings (P/E) multiple of 92, shares are significantly more expensive than Nvidia, which has a P/E of just 33 despite much better operational results.
Over the next five years, Arm Holdings stock will probably fall to a more reasonable valuation, because its business isn't growing fast enough to justify its current price tag. Investors who own shares should consider taking some profits off the table. But shorting the stock is extremely risky. The AI hype cycle is still in its early innings, and the market can stay irrational longer than you can stay solvent.
