On May 25, Nvidia shares made one of the biggest one-day moonshots in capital markets annals. It is the most significant case of investor drunkenness with artificial intelligence to date. Speaking on its Q1 2024 (ending April 30) earnings call, held the afternoon before, CFO Colette Kress emphasized that the designer and manufacturer of computer graphics processors expects massive expansion as data centers inevitably transition to their products with AI. “Generative AI is driving exponential growth in computing requirements and a rapid transition to NVIDIA-accelerated computing,” said Kress. In the press release, CEO Jensen Huang presented the kind of prediction for unlimited opportunities in AI that has reignited the rally in big tech. Huang wrote, “A trillion dollars of installed global data infrastructure will move… to accelerated computing as companies race to apply AI to every product, service and business process.”
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Nvidia’s market cap
Investors had already factored a huge premium into Nvidia’s market cap for that grand vision. What drove this May 25 launch was a huge surge in guidance that investors took as evidence that Nvidia AI is already starting to ride to one of its fastest profit explosions ever. Kress predicted third-quarter revenues will increase 52% to $11 billion, suggesting that Nvidia’s growth has reached a whole new gear. That news sent shares up 24% by mid-afternoon on May 25. In a single session, Nvidia’s market cap rose from $755 billion to $939 billion, or $184 billion. It is now worth two-thirds more than Tesla. Only Apple and Amazon and Microsoft have ever posted higher dollar profits in a single day, and each with a “puny” extra $7 billion to $191 billion.
Nvidia’s earnings outlook and stock price drivers
While the increase proved to be a rare stroke of luck for anyone who already owns shares of Nvidia, it makes it much more difficult for anyone buying the shares at these prices to earn a decent return. What looked difficult on May 24 looks virtually impossible on May 25. To understand why, let’s see how much Nvidia has to make in a decade to justify that current valuation on the portals of the $1 trillion club.
Keep in mind that the gap between Nvidia and the trillion-dollar club it’s almost a member of is that the other members, Apple, Microsoft, Amazon, and Google, have already made huge revenues that have lowered their PE ratios. For example, Apple has a multiple of 29 and looks extremely rich. Even assuming Nvidia meets its goal of more than 50% revenue growth for the second quarter, it will still sell at a stratospheric PE near 80.
Let’s assume that investors want a return of at least 10% per year to bet on Nvidia. It is a risky stock to say the least. The AI excitement has to go big for Nvidia to even stand a chance at the kind of success the market has built into its price. Nvidia pays a small dividend, but for this analysis we assume that it reinvests all profits and that all returns come from capital gains, in other words, an increase in the share price. If stocks reach our goal of increasing 10% per year by Spring 2033, Nvidia will boast a $2.5 trillion valuation.
Nvidia’s PE is astonishingly high
What is a reasonable PE in ten years? We’ll say 20, assuming Nvidia’s earnings growth will exceed its cost of capital, that it will clear into a high-octane phase well past our decade-long window. In that scenario, Nvidia should be making $125 billion a year in ten years. That’s a third more than Apple, America’s top earner, posted in the past four quarters.
To get there, Nvidia requires an average annual profit growth of 27% over a ten-year period. And that requirement assumes it won’t make large additions to its stock count, which could be necessary to fund the new manufacturing facilities needed to drive expansion in AI.
David Trainer, founder of investment research firm New Constructs, had a model showing that Nvidia does indeed have to climb a steep mountain, racing at top, unwavering speed, to reward investors. Trainer thinks Nvidia is a good buy, provided it can increase its current after-tax operating profit from the current 27% to nearly 45%, and increase revenues at 20% per year for the next 20 years.
How likely is Trainer to rate that wizard performance? “You’ve heard of priced for perfection,” he told Fortune. “This is priced for fantasy.” Of course, we’ve seen several tech champions achieve something like the feat that Nvidia achieves a lot. The problem: Nvidia’s already over 80% as expensive as Amazon and another half as expensive as former trillion club member Meta. Nvidia can still be a very successful company, but a bad investment because such Homeric expectations are already baked into the price. It’s best to take a deep breath, not get drunk on the vision and sober up on the numbers. Otherwise, a nasty hangover awaits.
This story was originally on Fortune.com
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