• Arm's stock fell after its latest quarterly report despite delivering better-than-expected numbers and impressive year-over-year growth.

• The stock is expensively valued right now, but Arm's ability to deliver robust earnings growth could help justify the numbers.

• The increasing demand for Arm's licenses and stronger royalty revenue are tailwinds investors should not ignore.

Expectations were high for Arm Holdings going into its fiscal 2025 third-quarter report (for the three months ended Dec. 31, 2024). Shares of the British company shot up remarkably in the past year and are trading at a premium valuation, so it wasn't surprising to see the stock fall when its outlook barely matched Wall Street's expectations.

Arm stock was down more than 3% after it released its quarterly results on Feb. 5. Though the company easily beat consensus estimates on both revenue and earnings, investors expected more in terms of fiscal Q4 guidance. However, a closer look at Arm's guidance suggests that investors may have overreacted.

Is Arm's pullback an opportunity to buy more shares? Let's find out.

Arm's guidance points toward an acceleration in growth

Arm reported a 19% year-over-year increase in revenue in fiscal Q3, along with a 26% spike in adjusted earnings per share. The company's guidance for the current quarter points toward a nice jump in both metrics on a year-over-year basis. More specifically, Arm is forecasting $1.23 billion in revenue and $0.52 per share in earnings for the current quarter at the midpoint of its guidance range.

The guidance indicates that Arm's revenue is on track to increase by 32% from the year-ago period, while earnings could increase by 44%. The company's earnings guidance matches consensus estimates, while the revenue guidance is a shade higher than expected. However, Arm's expensive sales multiple of 47 and earnings multiple of 214 explain why the company was expected to deliver even stronger growth during the quarter.

The bulls might argue that the acceleration in Arm's growth in the current quarter along with a slight improvement in the midpoint of its full-year guidance should be enough to justify its valuation. But the fact that Arm simply narrowed its fiscal 2025 guidance instead of upgrading it didn't sit well with investors.

After all, the company is targeting the fast-growing market for artificial intelligence (AI) chips with its latest architecture that's being used by chipmakers and consumer electronics companies to build their chips. More specifically, the adoption of the company's AI-focused Armv9 architecture is picking up in both the smartphone and cloud computing markets, leading to higher royalty revenue.

That's because Armv9 commands a higher royalty rate as compared to earlier architectures from the company. The good news for Arm investors is that Microsoft and Alphabet have started producing custom processors for handling AI workloads in data centers using Arm's architecture. That should pave the way for more royalty revenue going forward.

Meanwhile, the number of companies building chips using Arm architecture has also increased. This is evident from the fact that the number of licensees using Arm Total Access (ATA) jumped to 40 in the previous quarter from 27 in the same quarter last year. The company says  ATA is a "licensing model that provides the most comprehensive access to Arm IP products, tools and models, support and training, software, and physical IP in one easy-to-access subscription."

The demand for ATA increased last quarter from end markets such as smartphones, AI accelerators, and data centers, among others, suggesting that the demand for Arm's intellectual property (IP) remains robust. More importantly, as these licensees roll out chips based on Arm IP, the company's royalty revenue stream should get stronger.

Moreover, Arm is a part of the Stargate project backed by OpenAI, SoftBank, Oracle, and Abu Dhabi-based MGX. These companies are planning to invest $100 billion initially and $500 billion over the next four years to build out AI infrastructure in the U.S. Arm CEO Rene Haas suggests that this massive investment could give the company a shot in the arm. He remarked on the latest earnings conference call: "For Arm, we are extremely excited to be the CPU of choice for such a platform. Combined with the Blackwell CPU with Grace, Arm will be the CPU of choice for the initial configurations."

All this indicates that Arm has the potential to keep growing at a healthy pace in the long run.

But is the stock a buy?

Arm's updated earnings forecast for the current fiscal year indicates that its bottom line is on track to jump 26% to $1.60 per share. The forecast for the next couple of fiscal years points toward stronger growth in its earnings.

ARM EPS Estimates for Next Fiscal Year data by YCharts

That's not surprising as the growing number of licensees using Arm architecture to build chips is likely to lead to an increase in its royalty revenue, which is growing at an impressive pace thanks to the adoption of Armv9. For instance, Arm's royalty revenue increased 23% year over year in the latest quarter, outpacing the growth in its overall revenue.

The higher royalty rate that Armv9 commands has led to an improvement in the company's profitability.

ARM Profit Margin data by YCharts

As a result, the scope for stronger earnings growth at Arm going forward cannot be ruled out. Of course, the stock is trading at a premium valuation, but it may be able to justify that valuation with new business coming in thanks to catalysts such as Stargate. Growth investors can consider buying Arm stock on the dip as it seems built for long-term growth.