Should I Buy ARM Holdings or Imagination Technologies?

LONDON -- Smartphone chip pioneers ARM Holdings (ARM) (ARMH) and Imagination Technologies (IMG) have delivered share price gains of 839% and 408%, respectively, over the last five years, hammering the 8% price return delivered by the FTSE 100 over the same period.

Both companies now look pretty expensive, suggesting that further growth might already be priced into the shares. Given this, which company looks like the best investment for the next five years?

ARM Holdings vs. Imagination Technologies
I'm going to start with a look at a few key statistics that can be used to provide a quick comparison of these two companies, based on their last published results:

Both companies are intellectual property businesses -- they create chip designs which they license to other companies, who manufacture and sell the chips.

Although both companies have extremely high P/E ratios, ARM benefits from a much higher operating margin, which in turn helps justify its much higher P/S ratio.

However, ARM's greater size could be a disadvantage in terms of future growth -- Imagination's market cap is just 10% of ARM's, meaning it would probably be far easier for Imagination to double in size than it would be for ARM.

Imagination's recent $100 million acquisition of CPU designer MIPS Technologies should also help it generate growth, as it will expand the company's product range into new areas that should enable it to compete more closely with ARM.

What's next?
ARM and Imagination have profited from the global boom in smartphones, most of which use their chip designs. However, all booms eventually turn to bust, or become mature markets -- so what are the future growth prospects for these two firms?

Analysts' forecasts are notoriously unreliable, especially when they are focused on fast-growing stocks. However, apart from gut instinct, company and analyst forecasts are the only information we have available to judge the likely future growth of these companies' earnings.

With that in mind, let's take a look at some forward-looking numbers for ARM and Imagination Technologies. These apply to the companies' current financial years, and are only forecasts -- they may change:

These figures mean that even if ARM grows earnings per share by almost 50% in 2013, its shares will still trade on a P/E of 48, at their current price. Imagination's EPS growth forecast is similarly optimistic, although slightly more modest than for ARM.

Which share should I buy?
In my view, both companies' share prices are well into speculative territory: their premium P/E ratings make their share prices extremely sensitive to any slowdown in growth, and growth cannot be predicted that accurately.

It might be worth noting that ARM's board and senior management have been selling substantial portions of their shareholdings recently. In contrast, Imagination's directors have not sold any shares since January 2012, except for a small sale in March 2012.

My pick to buy would be Imagination Technologies, because I believe it is more likely to deliver strong growth or be profitably sold than its larger peer, ARM Holdings.

The top growth stock for 2013?
If investing in strong growth stocks like ARM and Imagination attracts you, I'd like to suggest you take a look at one U.K. stock that outperformed the FTSE 100 by 32% in 2012, and has delivered earnings-per-share growth of 44% since 2009.

It's already ahead of the FTSE 100 in 2013, too.

You can find full details of this company -- which the Fool's analysts believe could be seriously undervalued -- in this free report, "The Motley Fool's Top Growth Stock For 2013." Just click here to download your free copy now -- but hurry, it will only be available for a limited time.

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