Investors dream about buying into the sort of success story that Nvidia(NASDAQ: NVDA) has been over the past few years. Nvidia stock is up 30% in the past month alone. Over the last year, it has more than tripled.
That sounds great. But actually, the longer-term story has been even more impressive. In five years, the stock has jumped 2,760%. Yes, 2,760%!
At this point, with a market capitalisation of over $2.5tn, the chipmaker may look wildly overvalued. But is it?
Valuing growth stocks
One of the challenges here is the age-old conundrum of valuing a growth stock.
If I wanted to invest in a mature company with stable revenues and limited growth prospects, I could decide what sort of premium I was willing to pay for it – maybe 10 or 15 times earnings, for example.
But such a price-to-earnings (P/E) ratio approach can be more problematic when it comes to growth companies. Often, investors are basing valuations on expectations that a firm can grow its earnings dramatically.
The stock trades on a P/E ratio of 61. That is higher than I usually consider, but I do not see it as exceptional. Amazon has a P/E ratio of 51, for example.
Its earnings have exploded lately. This week, it reported that diluted earnings per share in the first quarter were 629% higher than in the same period last year.
If earnings continue to grow like that, the prospective P/E ratio is far lower than 61. In fact, Nvidia could turn out to be a bargain, even at today’s price.
Volatile earnings are a concern
That however, is a big ‘if’. Its surging earnings (and revenues) are proof that the market for its products is rapidly evolving.
Lately, that has been driven by booming demand for chips that can help customer implement AI solutions. That may continue. At some point though, I expect demand growth to slow and perhaps even start to reverse.
The lucrative market, combining surging demand with high profit margins, is also likely to attract competitors. That could put pressure on profit margins across the industry.
A lot to like
The firm has weapons in its arsenal against such a situation though. It has unique chip designs that competitors cannot replicate. It operates in an industry with high barriers to entry and it has proven expertise, as shown by its incredible growth.
In fact, I would happily own Nvidia in my portfolio if I could buy it at an attractive price. Even today’s price may look like a bargain five years from now.
But it could also look very expensive.
The earnings volatility here means I do not feel confident that the current share price is a bargain. The valuation feels too speculative for my risk profile as an investor. For now, I will not be buying.
This post was originally published on Motley Fool
