Extended Valuation Limits Near-Term Upside in Nvidia Stock

When it comes to Nvidia stock, improving fundamentals continue to trump a stretched valuation

About a month ago, I wrote in InvestorPlace that shares of semiconductor giant Nvidia (NASDAQ:NVDA) were locked in a tug-of-war between improving fundamentals and a stretched valuation, adding that improving fundamentals would win that tug-of-war for the foreseeable future as investors grew more optimistic about Nvidia’s ability to return to big growth rates in 2020.

Nvidia Stock has Ample Triggers to Take the Shares Higher
Source: Hairem / Shutterstock.com

Since then, NVDA stock has already risen more than 15% to fresh 52-week-highs on the back of easing trade tensions, improving semiconductor market conditions and rebounding economic activity. On the heels of such a big rally in such a short time, I think it’s appropriate to revisit the fundamentals versus valuation conversation, and see if the fundamentals still have enough firepower to keep powering Nvidia stock higher.

Do they? Yes, but in greatly limited capacity. It is already pushing up against its richest valuation levels ever. Sure, Nvidia stock deserves a premium valuation because of its robust long-term profit growth prospects in data, gaming, and automation. But, even if you look out long term, prices above $250 today are hard to justify.

At the same time, it’s hard to see NVDA stock falling by much in an environment where its fundamentals are dramatically improving.

Consequently, while fundamentals will continue to push Nvidia stock higher for the balance of 2020, the magnitude of those gains will be limited by what has turned into a stretched valuation.

Nvidia’s Fundamentals Are Improving

The simple truth behind the big recent rally in NVDA (up 50% over the past six months) is that investors are getting excited about the company’s growth trajectory finally turning around in 2020.

That is, Nvidia was once one of the best growth companies in the world, consistently firing off huge revenue and profit growth rates. Demand for the company’s graphics chips soared because of huge investment in future big-growth industries such as data-centers, virtual and augmented reality, machine learning, quantum computing, self-driving vehicles and more.

Then, the U.S.-China trade war hit. Demand from those end-markets froze amid increasing geopolitical uncertainty and a pullback in cryptocurrency mining. At the same time, because Nvidia didn’t see this demand slowdown coming, the company had amassed a huge supply glut of its GPUs.

The consequences were simple. Nvidia stopped growing. Revenues dropped. Margins got hit hard. Profits were wiped out. NVDA stock tanked.

In 2020, though, Nvidia will get back into growth mode.

Easing U.S.-China trade tensions and global monetary policies have laid the foundation for the global economy to meaningfully rebound in 2020 after slowing for much of 2018 and 2019. Amid these improving economic conditions, demand from Nvidia’s core end-markets will ramp back up. See Gartner’s projection for 2020 IT spend to rise 3.7%, versus a 0.4% rise in 2019. Or see the World Semiconductor Trade Statistics’s projection for 2020 semiconductor sales to rise 5.9% in 2020, compared to a 12.8% decline in 2019.

As demand from these end-markets ramps back up, revenues will soar higher. Margins will significantly expand. Profits will grow. And, presumably, NVDA stock will move higher.

Nvidia Stock is Richly Valued

The one thing which could hold NVDA back in 2020 is valuation. Specifically, because everyone sees this huge fundamental rebound coming, the market has already priced it in.

At $250 per share, Nvidia stock is trading at 45-times forward earnings. That is essentially an all time high valuation for Nvidia stock. The last time shares were this richly valued? Late 2018, before the stock proceeded to get cut in half in a matter of months.

Sure, I get that Nvidia deserves a premium valuation given the company’s favorable long-term growth prospects. I also understand that forward profit estimates are depressed because of trade tensions, and that earnings in five years will look a lot better than they do today.

Still, it’s tough for me to fundamentally justify a $250 price tag on NVDA stock.

My long-term model on Nvidia stock assumes: 1) the semiconductor market sustains above-average 5%-6% sales growth over the next several years, amid improving demand trends from data and AI end markets, 2) Nvidia expands share in that market given its favorable positioning in supplying the market’s big-growth verticals, and 3) profit margins at the company meaningfully expand back to and even above their all time highs.

Those are all favorable assumptions. Even so, they don’t support a $250 price tag for Nvidia stock today. Under those assumptions, I think $16.50 is a doable earnings per share level by fiscal 2026 (versus less than $6 expected in 2020 by Wall Street). Assuming the stock fetches an information technology sector-average 22-times forward earnings multiple, that implies a fiscal 2025 price target for NVDA of over $360.

Discounted back by 10% per year, that equates to a 2020 price target of about $225.

Bottom Line on NVDA Stock

Nvidia stock is presently immersed in a tug-of-war between improving fundamentals and a stretched valuation. Given the current market sentiment, I think improving fundamentals will continue winning out and shares will head higher. But persistent push-back from the valuation will ultimately limit the magnitude of further gains.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2020/01/extended-valuation-limits-near-term-upside-in-nvidia-stock/.

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