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Arm Holdings (NASDAQ: ARM) has only been public for eight months, but the semiconductor stock is already making waves in the stock market.

Arm attracted a ton of attention in February when the stock skyrocketed on its fiscal third-quarter results after the company made it clear that it would play a significant role in the artificial intelligence (AI) boom.

Shares nearly doubled in just three sessions following that earnings report. While the stock gave back a chunk of those gains in the subsequent weeks, Arm has remained one of a handful of stocks that are most closely associated with AI.

The company’s fiscal Q4 earnings report last Wednesday easily beat expectations as well, but the stock fell 2.3% on the news. Investors seemed to think its full-year guidance should have been stronger.

However, pullbacks can be buying opportunities, especially for otherwise strong businesses. Arm stock is still expensive, but the valuation looks more reasonable now — the price has come down since the February spike and after the company posted strong growth in Q4.

The company is generating wide profit margins, and based on its fiscal 2025 guidance, the stock now trades at a price-to-sales (P/S) ratio of 27 and a forward price-to-earnings (P/E) ratio of 66.

Is Arm stock a buy at those valuations? Here’s what you should know before you make your decision.

Image source: Getty Images.

Royalty revenue is just starting to ramp up

Arm has a unique business model in the semiconductor industry. Unlike its peers, the company doesn’t sell its products directly to its end users. Instead, it licenses its architecture and designs to partners like Nvidia and Apple, which use those chips in their products, and then generates royalty revenue when the products containing those chips are sold.

Typically, the company experiences a one to two-year lag between new licenses and the royalties that stem from that license.

Currently, the company is seeing a boom in license revenue related to AI demand as license revenue surged 60% to $414 million. However, those licenses won’t flow through into royalty revenue for at least a year or two, which means that Arm’s royalty revenue is likely to spike in fiscal 2026 and beyond.

In an interview with The Motley Fool, Arm CFO Jason Child said he envisioned the percentage of revenue coming from royalties to evolve from around 60% to more like 75% in a couple of years as the current license sales convert into products.

Royalty revenue also tends to be higher margin than license revenue, as royalty revenue typically comes from work that the company has already accounted for in previous years’ expenses. So Arm’s margins should expand as more of its revenue comes from royalties.

Guidance is likely conservative

Investors often like to focus on guidance rather than the results of the quarter just reported. On some level, that makes sense. Guidance is based on future results, and stocks are valued based on their future earnings. However, overemphasizing guidance can be a mistake as guidance is just a forecast and is often incorrect.

Tech companies in general skew toward giving conservative guidance as they tend to trade at high valuations and don’t want to miss their forecasts, and Arm seems to be establishing a similar pattern. The company has beaten guidance in all three of its earnings reports since going public, and while that pattern isn’t guaranteed to continue, it does seem likely to persist, though management acknowledged that license revenue could be lumpy from quarter to quarter.

Child said on the earnings call that the company expected to generate revenue growth of at least 20% for the next three years.

Based on Q4 results and the momentum in AI, it wouldn’t be surprising to see the company exceed that guidance. That means investors shouldn’t interpret the full-year guidance as cause for concern.

The moat is wide and getting wider

Arm distinguishes itself with its power-efficient central processing unit (CPU) architecture, and its chip designs are preferable in devices like smartphones and in AI data centers where conserving power is at a premium. Alternative CPUs like the X86 from Intel or AMD can’t compete with that.

That gives Arm a valuable competitive advantage and makes it a preferred partner for the likes of Nvidia and cloud-infrastructure companies like Microsoft, Amazon, and Alphabet. Management noted that the new Armv9 technology drove market-share gains in cloud servers, showing it’s gaining traction in the category involved in AI applications.

Child also told The Motley Fool that demand for Arm’s chips is accelerating because “software needs are outpacing the hardware capabilities” and power efficiency is a must for its customers. The demands of AI technology, then, are strengthening Arm’s competitive advantages, and if AI demand grows, Arm will be a major beneficiary. Not only will its top-line growth remain strong, but its margins should expand as it collects increased royalty revenue.

Is Arm stock a buy?

There’s still a lot of uncertainty in the AI boom, and that’s reflected in Arm’s relatively modest guidance. However, Arm’s technology will play a central role in the development of AI. The only question is how fast AI adoption grows and how far it goes.

From the recent results, it’s clear that momentum is building for Arm in AI, and investors should expect that trend to continue.

Arm stock is expensive, but it deserves a premium based on the accelerating growth and the opportunity in AI. Right now looks like an excellent time to scoop up shares of this AI stock as the price has moderated, and management shared plenty of reasons to be bullish in the latest update.

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Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Advanced Micro Devices, Apple, and Nvidia. The Motley Fool recommends Intel and recommends the following options: long January 2025 $45 calls on Intel and short May 2024 $47 calls on Intel. The Motley Fool has a disclosure policy.

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