Is Arm Stock an Undervalued AI Stock to Buy? | ARM Stock Analysis

Summary

In this video, the presenter conducts a discounted cash flow (DCF) valuation of ARM Holdings to determine its intrinsic stock value. The analysis reveals that, despite high earnings from licensing its technology, ARM's stock is significantly overvalued at its current price of $139 per share. Using free cash flow estimates and a high cost of capital driven by ARM's elevated beta, the intrinsic value is calculated at $29.98 per share. The presenter also highlights the importance of beta in the valuation process and offers scenarios to demonstrate the impact of different risk assumptions on the stock's worth.

Takeaways

• 😀 ARM Holdings generates high-margin revenue from licensing and royalties, attracting significant investor interest.
• 😀 The intrinsic value of ARM Holdings is estimated using a discounted cash flow (DCF) valuation model.
• 😀 ARM's projected free cash flows from 2024 to 2029 are provided by Wall Street analysts, ranging from $910M in 2024 to $3.73B in 2029.
• 😀 The company's market cap is $145 billion, with zero long-term debt and cash reserves of $1.5 billion.
• 😀 ARM Holdings has 1.06 billion shares outstanding, which is crucial for calculating the intrinsic value per share.
• 😀 A key factor in the valuation is ARM’s high beta of 4.46, which is adjusted to 2.25 for a more normalized rate.
• 😀 The weighted average cost of capital (WACC) is calculated at 17.24%, heavily influenced by ARM’s high beta and lack of debt.
• 😀 The intrinsic value per share is estimated to be $29.98, which is much lower than the current market price of $139 per share.
• 😀 Scenario analysis is conducted to explore different beta values, with intrinsic values ranging from $29.98 to $95 depending on beta adjustments.
• 😀 The high intrinsic value estimates suggest ARM's stock price is currently overvalued, driven by the company's high beta and perceived growth potential.
• 😀 Even though the market price is higher than the intrinsic value, the price may stay inflated as the market may continue to value ARM's growth prospects highly.

Q & A

What is the purpose of the discounted cash flow (DCF) valuation in this video?

The purpose of the DCF valuation is to determine the intrinsic value of ARM Holdings' stock by estimating its future cash flows and discounting them to their present value.

Why was ARM Holdings' beta adjusted from 4.46 to 2.25 in this analysis?

The beta was adjusted downwards to a more normalized level because a beta of 4.46 is considered too high, which would result in an exaggerated cost of capital. The adjusted beta better reflects ARM's risk profile.

What is the significance of beta in determining the stock’s intrinsic value?

Beta reflects the company’s risk relative to the market. A higher beta increases the cost of equity, which in turn raises the weighted average cost of capital (WACC), reducing the intrinsic value of the stock.

How were the cash flow estimates for ARM Holdings derived?

The cash flow estimates for ARM Holdings were derived from Wall Street analysts’ projections, which predict free cash flows for the company from 2024 to 2029, ranging from $910 million to $3.73 billion.

What is the weighted average cost of capital (WACC) for ARM Holdings, and how is it calculated?

The WACC for ARM Holdings is 17.24%. It is calculated by combining the cost of equity (17.7%) with the cost of debt, using the company’s capital structure. ARM has zero debt, so the WACC is mainly influenced by the cost of equity, which is based on the adjusted beta and the risk-free rate.

What is the terminal value in the context of DCF, and how is it calculated for ARM Holdings?

The terminal value represents the present value of all future cash flows beyond a certain point (2035 in this case). It is calculated using a perpetuity growth formula: free cash flow for the next year divided by the WACC minus the growth rate.

What are the projected growth rates for ARM Holdings' cash flows in the near and long term?

In the near term (2024-2029), ARM Holdings' cash flows are expected to grow at a rate of 32.7%. After 2029, the growth rate slows to 16.35% for five years, and then it is projected to stabilize at a long-term growth rate of 6% from 2035 onward.

Why is ARM Holdings’ intrinsic value calculated to be much lower than its market price?

ARM Holdings' intrinsic value is much lower than its market price because the high beta increases the cost of capital, which reduces the present value of future cash flows. This suggests the stock may be overvalued at its current market price of $139 per share.

How does the scenario analysis affect the valuation of ARM Holdings' stock?

The scenario analysis shows how changes in beta can significantly alter the stock's intrinsic value. For example, if the beta were 1 instead of 2.25, the intrinsic value would be $95 per share, showing that a lower beta would make the stock seem less overvalued.

What is the conclusion regarding ARM Holdings’ stock value from this analysis?

The conclusion is that ARM Holdings' stock appears overvalued based on the DCF valuation, with the intrinsic value per share estimated at $29.98 compared to the market price of $139 per share. However, the market may continue to value the stock higher due to factors not captured in the model, like future growth potential or market sentiment.