The race for artificial intelligence (AI) is in full swing, and advanced semiconductors are essential to meet vast data needs. You probably know chip manufacturers as Semiconductor manufacturing in Taiwan, Advanced microdevicesAnd Intelbut what about chip makers who don’t actually make chips?

Arm holds (NASDAQ:ARM) is such a company, and the stock is on fire, having risen 139% since its IPO and more than 215% in the past year. There’s a lot to like about the company, but the title may be ahead of its skis.

What does Arm Holdings do?

Arm Holdings is a vital cog in the semiconductor industry, even though it doesn’t make chips. Arm designs the framework, which it calls architecture, for advanced performance central processing units (CPU). Its clients use the designs as a basis to customize them according to their specific needs. You probably use an Arm-based chip every day since 99% of smartphones rely on an Arm-designed processor. Arm makes money by licensing architectures and collecting royalties for each product sold. To date, 280 billion have been shipped, according to Arm.

AI is a huge market for Arm. For example, MicrosoftThe Copilot+ PC, which integrates AI into Microsoft 365, uses Arm technology. The company expects 100 billion AI-enabled chips to be shipped by the end of fiscal 2026.

Investors should know about two other positive aspects of Arm’s business. First, its revenue from existing products lasts for decades. As shown below, new products accumulate revenue from existing products rather than cannibalizing them.

Data source: Arm Holdings.

Earning royalties on products developed a long time ago is very profitable because costs, such as research and development, were expensed when the products were developed.

Finally, Arm’s financial results are similar to those of software companies. As shown below, its gross margin is more comparable to the software company Palantir than Taiwan Semiconductor, which is also a wonderful company.

ARM gross profit margin (quarterly) data by Y Charts

The high gross margin means Arm will likely be very profitable as it grows. The company also produces healthy products free cash flow. Over the past 12 months, Arm reported free cash flow of $709 million on revenue of $3.5 billion. This 20% margin means that 20 cents of every dollar earned falls into the company’s pocket.

Arm is clearly a great company, but that doesn’t mean it’s a good investment at current prices.

It pays to be patient

Lou Simpson, one of Warren Buffett’s former stock pickers at Berkshire Hathawayonce said: “Even the largest company in the world is not a good investment if the price is too high.” » This appears to be the case with Arm stock.

As shown below, Arm’s valuation surpasses industry titan Microsoft and surpasses high-flying AI stock Palantir.

PS-BRAS report data by Y Charts

The downside risk is much higher than the upside potential, being more than 40 times greater than sales and 160 times greater than operating cash flow. Even taking into account sales growth, the future price/sales ratio only drops to 37, which remains very high.

Investors who want to own Arm can go about it in several ways. Averaging costs over a long period of time is a great strategy to reduce the risk of buying at an extravagant price. However, perhaps the best strategy is to watch the stock closely and wait for a significant drop in the stock price before buying.

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Bradley Guichard has no position in any of the stocks mentioned. The Motley Fool holds positions and recommends Advanced Micro Devices, Berkshire Hathaway, Microsoft, Palantir Technologies and Taiwan Semiconductor Manufacturing. The Motley Fool recommends Intel and recommends the following options: long January 2026 $395 calls on Microsoft, short January 2026 $405 calls on Microsoft, and short November 2024 $24 calls on Intel. The Motley Fool has a disclosure policy.