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After back-to-back record-setting performances in 2020 and 2021, the market for initial public offerings (IPOs) hit a slump. The general market downturn last year caused many companies to delay their market debuts, but there’s evidence of a rebound in the IPO market.

Exhibit A is the excitement surrounding the upcoming public debut of Arm Holdings. Nvidia (NASDAQ: NVDA) offered to buy the designer of central processing units (CPUs) used in smartphones for $40 billion in 2020, but regulatory challenges ultimately quashed the deal. Now, Arm is hoping to parley its expertise in semiconductors and the accelerating adoption of artificial intelligence (AI) into a $50 billion valuation, which would mark a big win for owner Softbank Group (OTC: SFTB.Y).

While there’s been massive interest in the debut among tech circles, there’s also a glaring red flag investors shouldn’t ignore.

Image source: Getty Images.

The details

In a revised F-1 that was released last week, Arm said it plans to list its shares on the Nasdaq Stock Exchange using the ticker “ARM.” The company initially planned to issue 95.5 million American depository shares, priced in a range of $47 to $51, which would have raised as much as $4.8 billion at the high end of the range, valuing the company at roughly $52 billion. After the offering, SoftBank would remain the majority shareholder, controlling nearly 91% of the stock.

Several reports emerged over the past week saying that Arm’s offering was “more than five times oversubscribed,” first reported by the Financial Times. This suggests that institutional investors, including investment banks and pension funds, are scrambling to take part in what could be the biggest IPO of the past couple of years.

Arm Holdings enlisted a cadre of investment banks to participate in its “road show,” or a series of presentations designed to educate investors about the company and its prospects. The report went on to note that the “sheer number of bankers involved … was itself a red flag.”

Softbank also lined up a veritable Who’s-Who technology companies, many of which are its biggest customers, to participate in the offering. Nvidia, Advanced Micro Devices, Apple, Alphabet, Intel, and Taiwan Semiconductor Manufacturing expressed an interest in purchasing as much as $735 million in Arm’s stock, though they aren’t obligated to do so.

Now, after drumming up a significant amount of interest, SoftBank is considering raising the proposed IPO stock price even higher in an effort to maximize its take from Arm’s IPO.

A steep valuation

Arm’s initial IPO price range would have already valued the company in pretty rarified territory.

For the fiscal year ended March 31, 2023, Arm generated revenue of $2.68 billion, which declined 1% year over year, resulting in net income of $524 million, down 5%. This suggests the company has yet to tap into the massive opportunity represented by generative AI — which would no doubt be reflected in its results.

A valuation of between $48 billion and $52 billion would have fetched a price-to-earnings (P/E) ratio of between 92 and 99 times its trailing 12-month earnings.

For context, Nvidia currently trades for 110 times trailing 12-month earnings. However, in its fiscal 2024 second quarter (ended Jul. 30), Nvidia generated revenue of $13.5 billion, up 101%, while net income of $6.2 billion soared 843%. That represents a stark contrast to a company attempting to paint itself as the next Nvidia.

There’s no denying Arm’s notable place in the semiconductor industry but given the frenzy surrounding its IPO, investors risk paying too high a price.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Danny Vena has positions in Alphabet, Apple, and Nvidia. The Motley Fool has positions in and recommends Advanced Micro Devices, Alphabet, Apple, Nvidia, and Taiwan Semiconductor Manufacturing. The Motley Fool recommends Intel and recommends the following options: long January 2023 $57.50 calls on Intel and long January 2025 $45 calls on Intel. The Motley Fool has a disclosure policy.

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