At a price-to-earnings (P/E) ratio of 72, Nvidia (NASDAQ:NVDA) shares look expensive. But I think investors should be wary of this idea without doing in-depth research.
The stock has traded at a high earnings multiple since 2019. That hasn’t stopped the share price rising by 1,920% over the last five years though.
P/E ratios
There’s no question Nvidia shares are aggressively priced, but this has been the case for some time. Over the last five years, the stock has barely traded at a P/E ratio below 35.
Nvidia P/E ratio 2019-24
Created at TradingView
Investors who let themselves be put off by this have missed out on huge returns. The reason is the company has consistently grown its earnings to justify the high price tag.
The most vivid illustration of this comes from the last 12 months. Last July, optimism about Nvidia’s position in the AI revolution caused the stock to trade at a P/E ratio close to 250.
Since then, however, the share price has roughly doubled. The reason is that Nvidia generated enough earnings growth to justify its valuation, increasing its earnings per share from $1.74 to $11.93.
Earnings growth
The last 12 months are an extreme example of what has been going on with Nvidia over the last five years. The stock has traded at a high price, but the company has achieved the growth to back it up.
Nvidia P/E ratio vs net income 2019-24
Created at TradingView
That’s why the stock has been such a good investment. But the company can’t grow earnings at 585% indefinitely, so there’s a question of whether it’s too late to buy Nvidia shares.
In 2019, when Nvidia made $4.14bn in net income, growing earnings at 20% meant generating an extra $828m in profits. But the equation is much more demanding now, with earnings at $29.76bn.
At today’s levels, a 20% earnings increase involves generating another $5.96bn in net income. For context, that’s the amount AstraZeneca made across its entire business in 2023.
Context
Growing at the rate of an AstraZeneca every year is going to be a challenge and there’s a risk the firm might not be able to do it. But there are some important considerations to keep in mind.
One is that Nvidia currently makes far less in net income than some of the other Magnificant Seven stocks. And I see that as a good thing – it means the company might have room to grow.
Nvidia vs Apple vs Microsoft net income 2019-24
Created at TradingView
Both Microsoft ($72bn) and Apple ($96bn) earn more than twice as much as Nvidia does. And if the company can reach these levels, the current share price implies a P/E ratio between 22 and 30.
Arguably, that’s not outrageously expensive. And it only depends on the business reaching the kind of profitability that other firms already achieve.
Are the shares still an opportunity?
The shares trade at a high P/E ratio. But the company has a strong record of growing its earnings to justify its share price.
If the business can reach the same profitability as Microsoft and Apple, I think it could be a great investment. So I wouldn’t rule out Nvidia as an AI stock to consider buying on that basis.
This post was originally published on Motley Fool
