When a stock triples in six months, the question inevitably becomes: Is this real? And that is the case for Nvidia Corp. (ticker: NVDA), the California-based chipmaker whose shares have zoomed higher this year on optimism that its products will lead the way in the artificial intelligence revolution.
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AI has been around for years, in some form, but the stock market’s focus on it has sharpened with last fall’s release of ChatGPT, a Microsoft-backed chatbot that uses AI to perform many of the functions of a search engine, gaining 100 million users within months. Nvidia’s gaming chips, long the envy of the industry, gave Nvidia an edge in pursuing emerging markets because its graphics and other capabilities anticipated the needs of metaverse, cloud computing and AI work, says Dan Ives, a tech analyst at Wedbush.
All the buzz has analysts projecting that Nvidia’s profits will also skyrocket, reaching as high as $8.90 a share this year after coming in at $1.76 in the fiscal year that ended in January. Then the inflection really starts: Consensus estimates for fiscal 2025 are as high as $14.33, with 2026 estimates ranging up to $19 a share. Does all of that justify a stock price of $430, though?
We looked for three reasons why investors might consider it, and three offsetting reasons why they might either sit this one out or wait for a dip before entering:
— Pro: The addressable markets are many and huge.
— Con: The markets are so big, competition is sure to be fierce.
— Pro: In a gold rush, bet on those who sell picks and shovels.
— Con: The valuation is really, really high.
— Pro: The company has been raising guidance sharply.
— Con: Cash-flow volatility, stock volatility and not much return of capital.
Pro: The Addressable Markets Are Many and Huge
AI isn’t a technology that does just one job. It’s a suite of capabilities that underpin advancements in a wide range of industries.
Nvidia’s products underpin AI efforts in industries as big as the health care and automotive industries, which each generate trillions of dollars a year in U.S. revenues. The reason: Nvidia’s capabilities for gaming chips turn out to be very transferable to AI technologies that depend on visualization, including medical imaging, and to genomics research. They even help create metaverse applications like avatars, including one of CEO Jensen Huang that the company slipped into a recent analyst presentation. And they are used throughout the cloud computing businesses that are thoroughly disrupting software.
Indeed, Nvidia’s growth in the quarter ending in April, which set off a huge rally in shares when it was disclosed in late May, was partly driven by a more than doubling of sales to auto-industry clients, to $294 million from $125 million a year earlier. Nvidia’s products are a big part of efforts to build cars with more safety features, the push toward self-driving vehicles, and products like enhanced infotainment systems that will let backseat passengers game on the way to school, Little League or grandma’s house.
At the same time, don’t sleep on Nvidia’s traditional business of making chips for games. At a June investor conference, Nvidia said its gaming revenue has grown more than 40% since 2020 and that more than half of its existing customers are overdue for upgrades.
“The computer industry is going through two simultaneous transitions — accelerated computing and generative AI,” Huang said in announcing first-quarter results. “A trillion dollars of installed global data center infrastructure will transition from general purpose to accelerated computing as companies race to apply generative AI into every product, service and business process.”
Con: The Markets Are So Big, Competition Is Sure to Be Fierce
The thing with giant markets is that they draw lots of competitors. In Nvidia’s case, a lot of that competition will come from current clients like Microsoft Corp. (MSFT), Apple Inc. (AAPL) and Tesla Inc. (TSLA), argues fund manager Cathie Wood, whose Ark Innovation ETF (ARKK) closed out its position in Nvidia in January. A related risk is that the tech sector’s focus on AI will lead to the development of cheaper, more specialized tools than some of Nvidia’s premium products.
“Tesla is coming up with its own chips,” Wood said in a May interview on Bloomberg TV. “Meta Platforms, Google, (are making) their own chips for more specialized large-language models. And the tech itself, and we’re learning from Meta Platforms that its LLaMA model is able to do with less computing power but more data to deliver better models. So there are puts and takes here, as there always are.”
Pro: In a Gold Rush, Bet on Those Who Sell Picks and Shovels
In 1848, the California gold rush set off a slow-motion stampede of covered wagons whose owners looked to dig money out of the ground. But there are two big companies founded around then in California that you may know: Levi Strauss & Co. (LEVI) and Wells Fargo & Co. (WFC), both of which got part of their start selling entrepreneurs what they needed.
Technology columnist Ina Fried points out that that isn’t uncommon: Picks and axes were big sellers in 1850s California too, just as internet “infrastructure” companies were popular during the late-1990s dot-com boom. Before you know which AI applications will be long-term winners, you’ll know for sure that the caravan of entrepreneurs will buy digital picks, shovels and blue jeans.
“Chip companies with products like Nvidia’s, which deliver the best performance on the kinds of tasks AI demands, are among the clearest initial beneficiaries of the AI boom,” Fried wrote. “At the onset of a new era, it’s impossible to know who will strike long-term gold. But, as was the case in 1849, it’s hard to go wrong in the short term by focusing on those with the best pick-axes.”
[READ: 6 of the Best AI ETFs to Buy for 2023]
Con: The Valuation Is Really, Really High
Given that shares have surged so much this year, it’s not surprising that some valuation metrics seem out of whack. The most popular knock on Nvidia is to complain that its price is 244 times 2023 profits and 25 times its sales. Which is, to be sure, far more than value stocks like banks and food companies, or even most tech firms, can command. But it’s more complicated than that, because Nvidia is growing so fast.
With profits expected to pop as AI becomes more ubiquitous, average analyst estimates say Nvidia will earn $7.40 a share this year and $9.93 next year. That puts the $430 shares at 58 times and 44 times estimates, which is still aggressive. (Microsoft’s current-year price-to-earnings ratio is 36). But there is an unusually wide range of estimates for Nvidia, too: Estimates for this year range from a low of $3.68 a share all the way up to nearly $9. The usual cliché about “consensus” estimates simply don’t apply here.
Growth stock analysts like a measure called the PEG ratio, which is the common P/E multiple divided by the rate of expected profit growth. This lets analysts value stocks based on what earnings might be three to five years down the road. Even by that measure, though, Nvidia’s PEG ratio of about 3 is much higher than growth stocks like Airbnb Inc. (ABNB). But, apply the highest earnings estimates and include more years of potential growth, and that PEG ratio comes down to less than 1, placing the stock in the bargain bin.
Valuing Nvidia boils down to this: Do you believe the earnings will rise that much?
Pro: The Company Has Been Raising Guidance Sharply
Well, maybe. This year’s spike has been driven since May by a huge jump in the guidance that Nvidia has been giving Wall Street about future revenue, Ives said. That raises the prospect that all the numbers behind arguments about valuation are too low.
“Nvidia gave revenue guidance for this coming quarter of $11 billion (plus or minus 2%), which is more than 50% higher than the Street’s forecast of $7 billion,” Ives said in a note to clients. “This is a game changer and will have a major ripple impact across the tech space.”
Nvidia’s shares also are riding the release of new products, Fried said. Huang disclosed that the company’s GH-200 “Superchip” for generative AI applications is now in production, as is an AI-focused supercomputer that uses the chips.
Con: Cash-Flow Volatility, Stock Volatility and Not Much Return of Capital
It won’t matter to most growth investors, but Nvidia has a tiny dividend (0.04% of the stock’s value annually, compared to about 1.7% for the S&P 500) and doesn’t buy back much of its own stock. Plus, it has had swings in its reported cash flow and share price. Operating cash flow dropped to $5.64 billion in fiscal 2023 from $9.11 billion the prior year, before rebounding sharply in the first quarter of this fiscal year, and stock buybacks dropped from more than $3 billion per quarter to a little more than $1 billion, according to YCharts.
With the company’s valuation around $1 trillion, that level of cash return won’t boost shares much. Instead, Huang is putting profits back into the business, spending more than 25% of first-quarter 2024 revenue on research and development.
Wood argues that the company “gets hit very hard by cycles” driven by parts shortages or otherwise. That’s one reason shares fell from a 2021 peak of $329.85 to a 2022 low of $112.26.
The bottom line is that no one really knows how fast AI will happen. By some measures, it’s overdue: People have been heralding its rise since the 1980s. But futurists like Ted Mortonson, technology strategist at Robert W. Baird & Co., say it could dramatically cut into employment and boost investment returns for years, as it buttresses productivity growth across the economy.
In that case, it’s wise to recall what tech research firm Gartner calls the hype cycle affecting most breakthroughs: They get oversold early on, often fall short of initial expectations for a while, and then deliver big over time.
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Should You Invest in Nvidia Stock? 3 Pros, 3 Cons originally appeared on usnews.com
Update 06/23/23: This story was previously published at an earlier date and has been updated with new information.
