The highly anticipated Nasdaq debut of Arm, the UK-based chip design company, has left SoftBank, its parent company, enthused but has left Wall Street perplexed. Following its IPO, Arm saw its stock skyrocket by 25% to $63.59, pushing its fully diluted market cap to a staggering $68 billion. While this appears to be an impressive achievement, it raises eyebrows given Arm’s relatively modest $400 million profit over the last four quarters. This valuation translates to a price-to-earnings (P/E) ratio of close to 170, dwarfing even Nvidia’s P/E ratio. Nvidia, a leader in graphics processing units (GPUs) for AI workloads, trades at 109 times trailing earnings, even after its stock price more than tripled this year, outperforming the entire S&P 500.
An Exceptional Growth Story: Nvidia vs. Arm
The key differentiator between Nvidia and Arm, according to investors, lies in their growth rates. Nvidia recently reported a doubling of revenue in the last quarter and has forecasted a further 170% expansion, driven by increased spending on AI chips by major cloud companies. In stark contrast, Arm’s revenue slightly declined in the previous quarter. Finance experts, such as Jay Ritter from the University of Florida, argue that a P/E ratio exceeding 100 is hard to justify for a company without significant growth prospects. Ritter suggests that for Arm to justify its valuation, it needs to develop new designs that will reignite growth and generate profits.
Limited Market Liquidity and Strategic Investors
Currently, there is limited open market availability for Arm’s stock. SoftBank, the majority shareholder, retains a 90% ownership stake out of the roughly 1.03 billion shares outstanding. SoftBank acquired Arm in 2016 for $32 billion and is seeking liquidity after a period of challenging investments. Only a small portion of the $4.9 billion worth of shares sold by SoftBank were purchased by strategic investors, including Apple, Google, Nvidia, Samsung, and Intel. The remaining shares are available for institutional and retail investors, and the volume of trading on the day of Arm’s IPO pushed it to become the fifth most actively traded stock on the Nasdaq.
To invest in Arm at its current valuation, a long-term investor must have confidence in its growth potential. Arm positions itself as a central player in the transition to AI-based computing, with its technology already integrated into smartphones, electric cars, and data centers. Arm’s CEO, Rene Haas, highlights the significant growth expected in cloud data centers, automotive, and AI, mentioning that “AI runs on Arm” and that Arm-based devices have become ubiquitous. According to Arm’s IPO filing, the addressable market for its designs is projected to reach $246.6 billion by 2025, indicating an annual growth rate of 6.8%. Arm’s path to prosperity will likely involve gaining market share and improving economics to capture a larger portion of each chip’s total value.
Investment experts, like Matt Oguz from Venture Science, offer a bullish outlook on Arm, noting its ability to maintain strong profit margins despite a slight revenue decline. Arm’s uniqueness arises from the extensive presence of its technology across key products. In fiscal 2023, Arm achieved a remarkable gross margin of 96%, primarily driven by the sale of royalties rather than hardware. In comparison, Nvidia’s gross margin in the last quarter stood at 70%, experiencing a substantial increase from under 44% a year earlier. Intel and AMD, on the other hand, recorded gross margins of 36% and 46%, respectively. With a solid operating margin of 25% in the latest quarter, Arm proved its resilience by remaining profitable while much of the chip industry struggled due to a post-Covid inventory glut.
The Complexity of Valuation: A Non-Commodity Company
Arm’s intricate financial profile and business model make it challenging to accurately calculate future earnings multiples. According to Oguz, Arm is far from being a commodity company, making it difficult to use traditional valuation metrics. The broad range of factors, including strong profit margins, global market presence, and the potential for future growth, necessitates a holistic assessment rather than a straightforward P/E ratio calculation.
Arm’s Nasdaq debut with an impressive valuation of nearly $68 billion has left Wall Street perplexed and intrigued in equal measure. While the market’s response indicates confidence in Arm’s growth prospects, skeptics question whether the company can justify its high valuation without substantial revenue growth. Arm’s success will hinge on capturing a larger market share, particularly in the AI and data center sectors. Nevertheless, with a unique technology presence and proven profitability, Arm presents an enigma for investors seeking the next big tech opportunity.
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