The fluctuations in profit growth projections provide a sobering assessment of the future prospects of the stock market darling.
Nvidia is undoubtedly a fantastic company, but is it also a wise investment?
Occasionally, a firm emerges that is so powerful and expanding so rapidly that it seems to be the only stock that matters. Naturally, I'm talking about Nvidia Corp., the massive chip manufacturer that powers artificial intelligence. With Microsoft Corp. and Apple Inc. as two of the biggest companies in the world, their stock has increased by 4,000% in the last five years.
Nvidia is deserving of all the praise. About 90% of the market is made up of its AI chips. With $80 billion in sales, it has the largest profit margin of any company with similar profitability in the S&P 500 Index, at 57%. Over the last five years, it has increased revenues at the fastest pace among S&P 500 firms, at 64% annually.
Nvidia is undoubtedly a fantastic company, but is it also a wise investment? One must also take valuation—often the opposite of profitability—into account in order to respond to that issue. Businesses that are successful and expand quickly often fetch a higher price, and Nvidia is no exception. Its value, at 76 times one-year trailing operating profits, is twice as pricey as Microsoft and Apple and more than three times that of the S&P 500.
Without a question, investors would argue that their bets are on Nvidia's future rather than its history and that the company's present price is justified by expected growth. The "long-term" profits growth predictions that experts project for firms throughout the course of their next business cycle, often spanning three to five years, are compiled by Bloomberg, which is a helpful resource. Consensus long-term growth rate for Nvidia is 43% annually, multiple times higher than Microsoft and Apple's and among the top for S&P 500 businesses.
Based on that trajectory, Nvidia's operating profits per share, which are now $19, should reach $80 in four years, meaning that the long-term price/earnings ratio, let's call it, will be 18. When ranked from highest to lowest among S&P 500 firms using that metric, Nvidia's long-term P/E ratio comes in at 116, almost exactly matching that of Apple and Microsoft. Put another way, even taking into consideration Nvidia's stronger projected growth, the price is comparable to that of the other industry heavyweights.
There's only one catch: analysts' profit estimates are more uncertain the farther ahead they attempt to estimate, and some firms are more dubious than others. Both Apple and Microsoft are established companies that profit from a client base that almost everyone with a screen has. Conversely, Nvidia caters to a relatively younger, but potentially more lucrative, AI-focused sector, the future of which, like Nvidia's position in it, is less assured.
As a result, one would anticipate greater dispute than that between Microsoft and Apple on Nvidia's future growth, and that is really the case. The standard deviation, or variability, of analysts' long-term profit growth projections is another figure that Bloomberg computes. Less agreement among analysts is indicated by more variability, and vice versa.
It turns out that Nvidia's long-term growth predictions are three times more variable than Microsoft's and four times more variable than Apple's. Therefore, even if the long-term P/E ratios of all three are comparable, Nvidia's is based on more optimistic but less predictable estimates, while Microsoft and Apple's are supported by more realistic but still reliable forecasts.
That emphasizes how dangerous it is to base a stock's present price only on projected earnings, especially when that view is unclear, as it seems to be with Nvidia. In the event that the company's consensus growth projections turn out to be too optimistic, the stock will revalue and has enough opportunity for correction.
Recently, Nvidia and Cisco Systems Inc. have been compared a lot, and for good reason. Cisco created the routers that drove the 1990s internet boom, and for a while, the craze for internet stocks made Cisco the most valuable company in the world. This is similar to how Nvidia's processors enable AI now.
The most illuminating aspect of that contrast is how Cisco's investors proved to be mistaken. Cisco increased its operational profitability by 71% annually between 1991 and 2000. The company reported $4.6 billion in earnings for the 2000 fiscal year and a high value of 233 times trailing earnings, which was undoubtedly supported by optimistic predictions for ongoing exceptional growth.
However, Cisco's fortunes swiftly changed in 2000 when the internet bubble burst. Operating profits fell to only $21 million in the fiscal year 2001. It took two years for operating earnings to return to 2000 levels, and by then, Cisco was trading at 39 times trailing earnings, or a small portion of its 2000 value. Since then, its worth has been declining.
While this does not imply that Nvidia will suffer a similar fate, it does highlight the dangers of placing too much faith in a promising future in a rapidly evolving sector. Parmy Olson, my colleague at Bloomberg Opinion, has already seen "signs of discontent" with AI, such as companies reducing their investment in new AI technologies.
Wedbush Securities analyst Daniel Ives recently said, "Nvidia's GPU chips are in essence the new gold or oil in the tech sector." Maybe it's no accident that both commodities have famously unpredictable futures
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