A price-to-earnings (P/E) ratio of almost 74 is generally considered a nosebleed valuation for any stock. To put that multiple into perspective, it’s almost three times the price-to-earnings ratio for the S&P500.
Nvidia (NASDAQ: NVDA) currently trading at almost 74 times last 12 months’ earnings. It’s no surprise that many investors think the chip stock has a high premium. But could they be wrong? Is Nvidia stock actually undervalued?
In the eyes of the beholder
First, let’s define the term “undervalued.” Oxford Languages, the world’s largest dictionary publisher, defines it as “not valued highly enough” or “having an underestimated financial value”.
I would say that any rational investor who owns Nvidia stock would think that the stock is undervalued by that definition. Why? There would be no point in holding the stock unless they believe that it is already sufficiently valued and appreciated or has a financial value that is higher than it should be.
Of course, not everyone will agree with these investors. But that’s the way the stock market works. Buyers of a stock think that a stock has more room to go up (i.e., it’s not valued high enough). Sellers usually don’t. Valuation, like beauty, is in the eye of the beholder.
Of the 36 analysts covered by LSEG In June 21, Nvidia was rated a Buy or Strong Buy. Many on Wall Street seem to view the stock as undervalued. How can they be so bullish given Nvidia’s sky-high price-to-earnings ratio? It’s easy: They think the company’s growth more than justifies its current price.
How much growth should Nvidia achieve?
That begs the next question: How much growth does Nvidia need to deliver to be undervalued now? There are several ways to determine an answer.
A quick and sloppy approach is to use the price-to-earnings-growth (PEG) ratio. This ratio is calculated by dividing the price-to-earnings ratio by the expected annual earnings per share (EPS) growth rate — usually the projected growth over the next five years. Any PEG ratio less than 1 is considered an attractive valuation.
The math is simple using the PEG ratio. Since Nvidia’s price-to-earnings ratio is almost 74, the company would need to generate annual earnings growth of about 74% over the next five years to be undervalued today. Some investors might believe that this lofty growth rate is entirely possible. After all, Nvidia’s earnings per share shot up 629% year over year in the first quarter of 2024. Growth could slow dramatically and still exceed 74%.
Another, more involved approach is to perform a discounted cash flow analysis. This method helps investors determine the current value of a stock using expected future cash flows. Aswath Damodaran, the NYU finance professor known as the “Dean of Valuation,” built a discounted cash flow model showing that Nvidia’s revenue can grow at a compound annual growth rate of 32.2% and still exceed 80 % may be overvalued.
A lame answer
Can Nvidia deliver enough revenue and profit growth over the next five years to make the stock truly undervalued? Maybe, but several things could get in the way. The current rush to develop generative AI apps could slow. Rivals could introduce new chips that eat into Nvidia’s market share.
Wall Street predicts Nvidia’s profits will grow about 43.2% annually over the next five years, according to LSEG. That’s stunning growth, but it’s not enough to bring Nvidia’s PEG ratio below 1.
I don’t believe Nvidia stock is undervalued using conventional valuation models. However, that doesn’t mean the momentum won’t continue. All it takes is enough investors think Nvidia stock has room to run and continue to be hand-picked. As I said before, valuation is in the eye of the beholder. Many investors view Nvidia as undervalued and may continue to do so.
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Keith Speights has no position in any of the stocks mentioned. The Motley Fool holds positions in and recommends Nvidia. The Motley Fool has a disclosure policy.
Is Nvidia stock actually undervalued? was originally published by The Motley Fool
