Today shares of Arm have fallen -5.1%, to a price of $141.44. Since it has an average rating of buy, many investors will be using today as an opportunity to buy the dip. But what if the stock is overvalued? Don't blindly trust analyst ratings before looking at the fundamentals yourself!
Arm has a P/E ratio of 471.5 based on its 12 month trailing earnings per share of $0.3. Considering its future earnings estimates of $2.07 per share, the stock's forward P/E ratio is 68.3. In comparison, the average P/E ratio of the Technology sector is 31.58 and the average P/E ratio of the S&P 500 is 28.21.
Arm's P/E ratio tells us how much investors are willing to pay for each dollar of the company's earnings. The problem with this metric is that it doesn't take into account the expected growth in earnings of the stock. Sometimes elevated P/E ratios can be justified by equally elevated growth expectations.
We can solve this inconsistency by dividing the company's trailing P/E ratio by its five year earnings growth estimate, which in this case gives us a 2.88 Price to Earnings Growth (PEG) ratio. Since the PEG ratio is greater than 1, the company's lofty valuation is not justified by its growth levels.
We can also compare the ratio of Arm's market price to its book value, which gives us the price to book, or P/B ratio. A company's book value refers to its present equity value -- or what is left over when we subtract its liabilities from its assets. ARM has a P/B ratio of 27.79, with any figure close to or below one indicating a potentially undervalued company.
A comparison of the share price versus company earnings and book value should be balanced by an analysis of the company's ability to pay its liabilities. One popular metric is the Quick Ratio, or Acid Test, which is the company's current assets minus its inventory and prepaid expenses divided by its current liabilities. Arm's quick ratio is 2.684. Generally speaking, a quick ratio above 1 signifies that the company is able to meet its liabilities.
Next up in our analysis is Arm's levered free cash flow, which stands at $998.0 Million. This represents the cash that is available to the company after all of its expenses and income are accounted for -- including those that arise outside of its core business activities. This money can be used to re-invest in the business or to payout a dividend. For now, at least, Arm has chosen the former.
With most indicators pointing at a higher than average valuation with uncertain growth prospects, most analysts are either wrong about Arm, or their research has uncovered one or more qualitative reasons to invest in the stock. For example, the strength of the management team and their plan for executing the business strategy may have convinced some analysts to give less weight to traditional quantitative factors.
