Nvidia is a must buy. Or is it?
In 2002, after the dot-com bubble burst and Sun Microsystems swooned, company co-founder Scott McNealy highlighted the folly of Wall Street analysts who favored one financial metric to gauge a stock's value: its price in relation to the company's sales.
Mr. McNealy mused on the price-to-sales ratio – a key measure of a company's value relative to the amount of money it generates. A high ratio may be justified if investors believe a company has room to grow; a low ratio usually indicates that investors believe the company is accurately valued.
Based on that measure, analysts had guessed that Sun's stock was undervalued, even if its price was more than 10 times its revenue — a value the company ultimately wouldn't be able to sustain. Even if Sun had passed on every dollar it made at the time to investors, it would have taken them ten years to recoup their investment.
“Do you realize how ridiculous those principles are?” Mr. McNealy told Businessweek. “You don't need transparency. You don't need footnotes. What did you think?”
Today's stock market is creating a similar sentiment among some investors, led by giant chipmaker Nvidia, the poster child for the artificial intelligence exuberance. On Wednesday, Nvidia's share price closed at 27 times sales.
Nvidia is very different from the hundreds of revenue-rich but profitable companies that the market welcomed in the late 1990s. The Santa Clara, California-based company is wildly 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 higher than a year earlier.
But does Nvidia have enough room to grow to justify such a high price-to-sales figure, or is it magical thinking on the part of over-enthusiastic investors? Experts are divided.
The high price-to-sales ratio is rooted in the firm belief of many Nvidia enthusiasts that the company will continue to grow because of its crucial role in artificial intelligence. Even if a ratio of 27 times sales implies a large growth expectation for the company, many investors still view Nvidia as undervalued because they expect it to continue to generate more and more money – until eventually the price-to-sales ratio shrinks to the level of a more sedate, corporate behemoth.
That has already started to happen. Before reporting new earnings on Wednesday, the company was trading at a ratio closer to 30 times its revenue. 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. Mr. Rasgon still expects Nvidia's value to be “materially higher” in five to 10 years.
But Nvidia isn't the only company making waves, even if it is the most high-profile. Microsoft, Advanced Micro Devices and Broadcom are among the companies that have seen their prices rise above tenfold of sales in the past year, as beneficiaries of the general excitement around AI
For some investors, uncertainty about whether the bet will succeed makes the high price of stocks like Nvidia uncomfortable, especially when there is a lack of clarity about the path of inflation and interest rates, as well as political uncertainty from Ukraine, China, the Middle East and at home in the run-up to the presidential elections.
“What kind of return do you actually get if you take all that risk?” said Matt Smith, investment director at Ruffer, a London-based fund manager.
Another popular measure, the price-to-earnings ratio, shows that the S&P 500 now trades almost 23 times the collective earnings of the companies in the index. Putting aside the pandemonium surrounding the pandemic, the last time the ratio was this high was just before the market stalled in 2018. Before that, it was when the dotcom bubble burst.
For stock prices to continue rising from here, earnings must continue to grow, otherwise these stock picker-favored metrics must rise even further above their historical norms.
“Valuations are already historically rich,” said Jordon Brooks, co-head of the macro strategies group at trading firm AQR. “And then we would be talking about a dramatic expansion of these areas from here.”
However, relying on snapshot statistics oversimplifies whether a stock still offers value for money, says Aswath Damodaran, professor of finance at New York University's Stern School of Business, where he teaches stock valuation.
Amazon was trading at a stock price of more than 40 times sales in January 1999. Since then, the share price has risen by an average of 15 percent annually. Revenues have grown even faster. Today, its stock is priced at just three times its revenue, and it has been one of the best investments in the S&P 500 over the past two decades.
Nvidia could be the next Amazon and meet investors' growth expectations. Or it could be more like the dozens of computer companies that came to prominence in the 1980s but didn't last until 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 fallen from over $100 to less than $20. Less than a decade later, the company went bankrupt.
“People said PCs would take over the world,” Mr Damodaran said. “They were right. But where they got it wrong was that all the companies that made PCs in the 1980s didn't make it.”
The same will likely be true for many of the companies swept up in the AI boom, he added.
Even when it comes to broad indexes like the S&P 500, simple numbers don't tell the whole story. Remove the so-called Magnificent Seven stocks, like Nvidia, whose size has had a big impact on the S&P 500's overall performance, and the index looks much more modestly priced compared to its past performance.
Choosing 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 divergent expectations among Wall Street analysts, with the most pessimistic seeing Nvidia's true share value closer to $400, not Wednesday's closing price of $674, while others think the price should be above $1,000.
Mr Damodaran sees such high expectations as “unrealistic”.
“It's the nature of the beast,” he says. “We think we can do more than we can. When a big change is coming, we overestimate.”