The U.S. stock market just had another fantastic year. The broad-based S&P 500 (^GSPC 0.16%) returned 23%, the blue-chip Dow Jones Industrial Average (^DJI 0.25%) advanced 13%, and the technology-focused Nasdaq Composite (^IXIC -0.06%) surged 29% in 2024.

Excitement about artificial intelligence (AI) was once again the defining investment theme last year, and it will likely be just as important this year. Indeed, two Morgan Stanley analysts have outlined bull-case scenarios in which Datadog (DDOG 0.34%) and Arm Holdings (ARM 0.57%) generate monster returns as AI supercharges their businesses.

  • Sanjit Singh at Morgan Stanley has set Datadog with a bull-case target of $205 per share. That implies 45% upside from its current share price of $141.
  • Lee Simpson at Morgan Stanley has set Arm with a bull-case target of $300 per share. That implies 108% upside from its current share price of $144.

Here's what investors should know about Datadog and Arm.

Datadog: 45% implied upside

Datadog provides observability software. Its platform includes nearly two dozen products that help businesses monitor their critical applications and infrastructure. In doing so, Datadog helps customers identify and resolve peformance issues, while enabling better collaboration between development and operations teams.

Consultancy Gartner recently ranked Datadog as a leader in observability and digital experience monitoring software. Spending in that market is forecast to grow at 12% annually through 2027 as cloud migration and digital transformation make computing environments more complex. Artificial intelligence (AI) in particular should be a major tailwind, and the company is rolling out new products to meet demand.

Last year, Datadog introduced LLM Observability, a software module that lets developers monitor generative AI applications and the underlying large language models (LLMs). CEO Olivier Pomel recently said hundreds of customers are already using the product, and AI-native clients accounted for 4 percentage points of revenue growth in the recent quarter, up from 2 point in the same quarter last year.

Wall Street expects Datadog's adjusted earnings to increase at 13% annually through 2026. That consensus estimate makes the current valuation of 75 times adjusted earnings look expensive. Not surprisingly, Morgan Stanley's bull-case target is based on revenue increasing at 28% annually through 2026, which implies earnings growth well above the consensus.

I think that outcome is plausible, perhaps even likely. Datadog's earnings have topped the consensus estimate in the last 12 quarters. But the stock would still need a very expensive valuation to generate a 45% return in 2025. Investors shouldn't count on that happening. But Datadog is still an excellent company with solid growth prospects, so long-term investors should look for opportunities to buy on dips.

Arm Holdings: 108% implied upside

Arm designs central processing unit (CPU) architectures and sells the instruction sets to other companies. Those clients use the intellectual property (IP) to build chips optimized for use cases across mobile devices, automotive systems, industrial sensors, and data center servers. Arm also provides development tools that helps engineers configure systems and programmers write applications.

Arm's unique business models lets companies outsource some R&D expenses associated with chip design, while still retaining the flexibility to build custom processors. Arm architecture has a reputation for superior power efficiency, so much so that the company has more than 99% market share in smartphones. But that quality also makes its chips compelling for energy-intensive data center workloads like artificial intelligence.

Importantly, Arm gained six percentage points of market share in cloud computing in the last two years as its chips became more powerful. Today, 10 of the largest hyperscalers in the world are building Arm-based chips for their data center servers, including Amazon, Microsoft, and Alphabet. That positions Arm for further share gains in the coming years as businesses seek out cost-efficient AI infrastructure.

Wall Street expects Arm's adjusted earnings to increase at 33% annually through fiscal 2027, which ends in March 2027. That consensus makes the current valuation of 104 times adjusted earnings look expensive. Not surprisingly, Morgan Stanley's bull-case target is based on much faster growth, driven in part by demand for AI server chips.

While that is certainly plausible given that Arm has topped expectations in recent quarters, I am still skeptical about the stock returning more than 100% this year. Earnings would either need to increase much faster than expected, or else the stock would need an even more expensive valuation. Investors shouldn't count on either outcome.

However, Arm is a worthwhile long-term investment given its unique business model. I think more compelling buying opportunities will present themselves in the future, but patient investors eager to own shares could start with a very small position today.