Looking at the current valuation of Arm Holdings (ARM), the word “astronomical" comes to mind. Arm's market capitalization currently stands at $319 billion. If we glance into the fundamentals, the scale of investors' optimism becomes even more obvious; Arm's annual revenue is around $4.9 billion, while net profit is roughly $900 million. Yes, gross profit sits at an impressive $4.8 billion, which demonstrates the beauty of the business model. Still, the trailing price-to-earnings (P/E) multiple is a staggering 365 times.
Arm’s business model is indeed phenomenal. The company controls the main architecture on which the creation of processors is based, and it doesn't even need to produce anything physically. This is intellectual property (IP) in its purest form — anyone who makes Arm-based chips is obligated to pay a royalty. The more chips produced, the more the company earns.
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Thanks to this control, the market began to value ARM as an "eternal" asset. The exceptionally high P/E means that investors are ready to pay for years of advancing profits. This implies that Arm's technologically dominant position is expected to exist essentially forever. But in the world of physics and technology, nothing lasts forever.
Arm Faces a Collision With the Laws of Physics
The main problem with projecting the business of Arm into infinity is that the base technology in which it dominates — traditional silicon chips — is rapidly approaching its absolute physical limits.
Moore's Law and the miniaturization of transistors cannot continue forever. Right now, the industry is mastering 2-nanometer (2nm) nodes, and 1.4nm chips are on the horizon. From there, factories may be able to squeeze chip technology into the 1nm realm, but anything smaller looks impossible.
We are approaching the size of an atom. The width of the channel of a transistor physically cannot be smaller than several atoms, otherwise quantum effects come into play and the laws of physics simply will not allow the chip to work. Yes, the industry is attempting to bypass this dead end, creating 3D-stacked chips. But this only provides a linear increase of area and density. This is not a fundamental breakthrough; it merely delays the inevitable end of the current silicon architecture.
A Looming Paradigm Shift
In 10, 15, or 20 years, humanity will face a complete dead end in the development of traditional chips. To continue building up computing capacities will require a transition to fundamentally new technologies — be that photonic, optical, or quantum processors.
Here lies the main risk for the current valuation of ARM stock. Arm's IP covers modern silicon architectures, but the company does not have any guaranteed rights on the technologies that will eventually replace traditional chips in the decades to come.
Possessing IP used by almost the entire modern chip industry is an unconditionally staggering and powerful market position. However, investors must clearly understand that nothing in this world lasts forever. Technologies change, and physical limits are insurmountable. This is exactly why Arm's P/E ratio — just like any other company in the world, under any circumstances — should not be projected into infinity.
The current valuation of ARM stock is not a reason to buy or a signal to sell. Rather, this is only a reminder that even the most brilliant businesses have their historical and technological expiration dates.
On the date of publication, Mikhail Fedorov did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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