Nvidia is a must buy. Or is that it?

Nvidia is a must buy.  Or is that it?

In 2002, after the dot-com bubble burst and Sun Microsystems collapsed, the company’s co-founder Scott McNealy highlighted the folly of Wall Street analysts who favored a particular financial metric to measure the value of a stock: its price in relation to the company’s sales.

McNealy was reflecting on the price-to-sales ratio, an important measure of a company’s value relative to the amount of cash it generates. A high ratio can be justified if investors believe a company has room to grow; A low ratio usually indicates that investors believe the company is accurately valued.

Using that metric, analysts had bet that Sun’s stock was undervalued even as it traded at more than 10 times its revenue, a value its business ultimately couldn’t sustain. Even if Sun transferred every dollar he was earning at the time to investors, it would have taken them a decade to recoup their investment.

“Do you realize how ridiculous those basic assumptions are?” McNealy told Businessweek. “No transparency is needed. You don’t need footnotes. What were you thinking?”

Today’s stock market is evoking a similar sentiment among some investors, led by chipmaker giant Nvidia, the perfect example of the exuberance around artificial intelligence. On Wednesday, Nvidia’s stock price closed at 27 times its sales.

Nvidia is very different from the hundreds of revenue-rich but profit-less companies that the market applauded in the late 1990s. The company, based in Santa Clara, California, is enormously profitable: in the last three months of 2023, it generated more than $22 billion in revenue, up 22 percent from the previous quarter and more than 250 percent up from the previous year.

But does Nvidia have enough room to grow to justify such a high price-to-sales ratio, or is this magical thinking on the part of overexcited investors? Experts are divided.

The high price-to-sales ratio is based on a firm belief among many Nvidia enthusiasts that the company will continue to grow due to its pivotal role in artificial intelligence. Even if a 27 times sales ratio creates a strong growth outlook for the company, many investors still consider Nvidia to be undervalued because they expect it to continue generating more and more cash, until eventually the price-to-sales ratio drops to level of a more serious corporate giant.

That has already started to happen. Before reporting new earnings on Wednesday, the company was trading at a ratio close to 30 times its sales. In June, it was above 45.

“The numbers have gotten so big, so quickly,” said Stacy Rasgon, an analyst at AB Bernstein who covers Nvidia. Rasgon still expects Nvidia’s value to be “materially higher” in five to ten years.

But Nvidia is not the only company that causes consternation, even if it is the most surprising. Microsoft, Advanced Micro Devices and Broadcom are among companies whose prices have increased more than 10 times sales in the last year, as beneficiaries of the general enthusiasm around AI.

For some investors, uncertainty about whether the bet will succeed makes the high price of stocks like Nvidia unpalatable, especially when there is a lack of clarity around the path of inflation and interest rates, as well as political uncertainty. from Ukraine, China, the Middle East and at home ahead of the presidential election.

“What return do you really get for taking all that risk?” said Matt Smith, chief investment officer at Ruffer, a London-based fund manager.

Another popular metric, the price-to-earnings ratio, shows that the S&P 500 now trades at about 23 times the collective earnings of the companies in the index. Excluding the chaos around the pandemic, the last time the ratio was this high was just before the market tanked in 2018. Before that, it was when the dot-com bubble burst.

For stock prices to continue rising from here, either earnings have to continue growing or these stock-picker-preferred metrics would have to surpass their historical norms even further.

“Valuations are already historically rich,” said Jordon Brooks, co-head of trading firm AQR’s macro strategies group. “And we would be talking about them expanding dramatically from here.”

However, relying on snapshot metrics oversimplifies whether a stock is still a good value, said Aswath Damodaran, a finance professor at New York University’s Stern School of Business, where he teaches on stock valuation.

In January 1999, Amazon was trading at a share price equal to more than 40 times its sales. Since then, its share price has risen an average of 15 percent annually. Its income has grown even faster. Today, its shares barely triple its sales and it has been one of the best investments in the S&P 500 in the last 20 years.

Nvidia could be the next Amazon and meet investors’ growth expectations. Or it could end up more like the dozens of computer companies that rose to prominence in the 1980s but didn’t last into the new millennium.

In 1982, Commodore International sold the second most popular personal computer: the Commodore 64. By early 1985 it had lost its competitive advantage and its stock price had plummeted from more than $100 to less than $20. Less than a decade later, the company went bankrupt.

“People said the PCs were going to take over the world,” Damodaran said. “They were right. But what they got wrong was that all the companies that made PCs in the 1980s didn’t make it.”

The same is likely true for many of the companies swept up in the AI ​​boom, he added.

Similarly, when it comes to broad indices like the S&P 500, simple metrics don’t tell the whole story. If you remove so-called Magnificent Seven stocks, such as Nvidia, whose size has had a big impact on the overall performance of the S&P 500, the index appears to be much more modestly priced compared to its past performance.

Picking the Amazons and avoiding the Commodores is still not easy.

Such analysis is inherently based on assumptions about the future: a company’s future profitability, its future competitors, and even the future of the world in which it will exist. That uncertainty helps explain the wide range of expectations among Wall Street analysts: the most pessimistic believe that the true value of Nvidia shares will be closer to $400, not Wednesday’s closing price of $674, while that others think it should be priced above $1,000.

Damodaran considers such high expectations “unrealistic.”

“It’s the nature of the beast,” he said. “We believe we can do more than we can. “When big change is coming, we overestimate it.”

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John C. Johnson

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