Nvidia (NASDAQ:NVDA) did it again. A few days ago, Nvidia stock topped expectations in Q2, adding another strong quarterly result to its recent highlight reel.
It’s been a nearly unblemished winning streak for Nvidia since 2016. Investors have already forgotten the brief crypto-induced blip in 2018, and NVDA stock is ramping up once again to fresh all-time highs.
But is the enthusiasm justified?
Second-quarter earnings were revealing in a way. Despite another set of blowout numbers, NVDA stock hardly budged. In fact, shares actually dipped a bit in the immediate wake of the earnings release.
If the figures were so amazing, why didn’t the stock rally? It’s because shares are already so expensive that it’s hard to justify further upside at this point.
A Simple Valuation Problem
Almost any way you cut it, NVDA stock is dramatically overpriced. Many investors look at earnings first, and here Nvidia comes up far short. The company currently goes for 65x earnings. Even if the company is able to meet analyst expectations next year, the company is slated to earn just $9 per share, which would still amount to a 54x forward price-earnings ratio.
Let’s suppose Nvidia continues to dominate all competition and grow at lightning speed for the next five years. Assuming this optimistic view, where would that put Nvidia? Fortunately, Bank of America’s analysts did the work and concluded that:
“Bigger picture, we believe [Nvidia] has an unassailable hardware/software/developer lead in some of the largest and fastest growing markets in semis/tech (AI, Gaming, Autonomous), all derived from a common architecture, that can potentially drive sales at a 20%+, EPS at a 25%+ pace to head towards $22/sh by CY24E.”
Got that? Even in this everything goes well for the next five years, Nvidia would still only earn $22 per share annually of profit at that point. That’d put the stock at 23x 2024 earnings. You know you’ve got a valuation puzzle on your hands if you assume half a decade of future blockbuster growth and your stock still looks expensive.
Finally, consider Nvidia’s dividend yield. As recently as 2016, NVDA stock offered a decent 1.5% dividend. Since then, Nvidia has increased its dividend payment every year. Despite that, its dividend yield has plummeted to a pathetic 0.15% now. It’s not even that Nvidia is particularly stingy either, it’s just that there are hardly any earnings to pass out to shareholders.
Nvidia’s stock price has gone on a rocket trip that is detached from any serious connection to Nvidia’s underlying earnings or business performance.
The Arguments For $500 Nvidia
If Nvidia is egregiously expensive, as I argue, then what could justify the stock price up here? One common argument is that with interest rates plunging to record lows, the value of stocks is higher than ever. If you can’t get any returns from bonds or cash, then you have to invest in stocks. There is no alternative, as they say.
This is a fair and correct argument to a degree. However, it’s one thing to argue that a growth stock should trade at 25x earnings instead of 20x because of higher rates. Similarly, maybe fast-growing tech companies should go for 8x sales instead of 6x. That’s a reasonable argument.
However, 65x earnings and 25x sales is a whole different ball game. Just look at the majority of big tech stocks. Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), and Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) trade for much lower valuations than Nvidia. That’s even before you get to stable but slow-growth tech companies like Intel (NASDAQ:INTC) or Cisco (NASDAQ:CSCO). Lower interest rates alone don’t justify anything close to Nvidia’s valuation.
True, Nvidia is growing more quickly than those other companies. But then we’re back to the problem of (over)valuation for growth. Nvidia has been growing earnings and revenues at a compounded 15-20% range in recent years. Again, you simply don’t pay 65x earnings and 25x revenues for that moderate growth rate. You can find lightning-fast growth in software-as-a-service stocks at more attractive valuations than Nvidia.
Finally, bulls argue that Nvidia has promising technology and thus will continue to pull farther ahead of rivals. That’s possible, but is it likely? Nvidia has already been on a long winning streak despite having a far smaller research and development budget than Intel and other large peers. Is it more likely that Nvidia will continue to flawlessly execute, or that it will experience some regression to the mean?
NVDA Stock Verdict
Nvidia stock is ripe for a big correction. After the past few years, Nvidia has taken on an aura of invincibility. The company has enjoyed tremendous success in nearly every area where it competes. It’s taken a big chunk out of Intel in some markets. The self-driving efforts are moving along, and Nvidia’s gaming chips remain best-in-class.
At this point, though, what more could possibly go right for Nvidia? Meanwhile, there’s all sorts of things that could go wrong. The phrase “priced for perfection” was created for situations just like this. When it would take five years of rapid growth to get Nvidia stock back to a more normal valuation, you have a dangerous investment.
Expect NVDA stock to correct sharply in coming months.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he owned FB and INTC stock.