It has been a fantastic year for big capitalization tech stocks. And even among that distinguished group, Nvidia’s (NASDAQ:NVDA) results have been noteworthy. NVDA stock is 182% over the past year, and 97% over the past six months.
However, after a scorching run in recent years, it’s hard to see how the party can continue. Even with Nvidia doing everything right on a corporate level, the stock has simply gotten too far ahead of the underlying business.
It’s important to remember that a stock and a company are two distinct things. Regardless of how great the company is right now, NVDA stock has become a gamble due to its lofty valuation.
Yes, I realize there’s excitement around a potential deal to acquire Arm Holdings, a leading semiconductor design firm. But even that wouldn’t change Nvidia’s outlook materially in the near-term. Here’s why.
Arm Won’t Lift NVDA Stock Enough
The issue with the potential Arm acquisition deal is this: it’s just not big enough.
That may sound weird. After all, Nvidia is offering $40 billion for Arm. But, put it in context. Nvidia now has a market capitalization of almost $350 billion. A $40 billion deal — while impressive — is only a fraction of NVDA’s current valuation. And Arm is not without its risks, either.
A clear leader within its industry, Arm’s focus on artificial intelligence is promising. It’s a natural fit with Nvidia’s own priorities, and the company could undoubtedly jump-start Arm’s business.
But Arm has also been struggling in recent years. Softbank (OTCMKTS:SFTBY) purchased Arm for a little under $32 billion back in 2016. Since then, it has floundered. The company has failed to turn its technical achievements into commercial success.
While Arm could be an incremental benefit, a floundering asset of this size won’t significantly change Nvidia’s fortunes.
Too Big Too Succeed?
Simply put, there are limits to growth. And NVDA stock is about to hit some of them — at least in the short run. The company already became one of the world’s largest semiconductor firms earlier this year. From that high vantage point, it’s worth asking just how much farther the stock can realistically go.
Nvidia has returned to earnings and revenue growth this year. But it’s also worth remembering that Nvidia’s revenues for fiscal year ’20 (which ended early this year) dropped 7% and GAAP (generally accepted accounting principles) earnings per diluted share dropped 32%.
Fiscal year 2021 will see a solid pick-up, with earnings of $9 per share, according to analyst estimates. However, growth will be moderate going forward, with a forecast in the 20% range for the next five years.
And that simply isn’t impressive enough for a stock that is already over $550. It’s one thing to grow exponentially when you’re a small company. But when you’re already the king of your sector, it gets harder to justify an inflated valuation.
Corrections Are Inevitable
Even with Nvidia’s incredible run over the past five years, it’s important not to forget the painful corrections along the way. With the Bitcoin crash in 2018, Nvidia’s graphic card sales slowed when the demand for cryptomining units slid. That loss of momentum came unexpectedly, and resulted in a crushing blow.
In a three-month period in late 2018, NVDA stock lost more than half its value from peak to trough. It took the company until early 2020 to reclaim the ground in lost in that frantic three-month sell-off.
I bring this up because it’s important to remember that — despite Nvidia operational success — it’s earnings are not impenetrable to hiccups. This always happens with growth companies, sooner or later.
And when you’re selling at 52 times forward earnings, and the stock price has more than doubled over the past 12 months, you’re not giving yourself much room for error. In Nvidia’s case, the stock was trading at $250 at the start of 2020. Now it’s at over $550. Would it be a shock if Nvidia’s shares fell back to $400? That’d still be a huge gain for the year. But for anyone buying shares today, it’d be a massive setback.
Nvidia is having a tremendous run, both in its stock price and its business fundamentals. However, the former has far outstripped the latter. Since 2016, Nvidia’s revenues are up a little more than 100%, operating profit has tripled, and earnings are up five-fold. That’s all incredible stuff.
However, NVDA stock is up about 1,700% over the same stretch. That’s simply way ahead of the company’s growth. Nvidia’s market cap has now swollen so much that even a $40 billion acquisition hardly moves the needle. If you are a long-term investor that intends to hold onto Nvidia forever, that’s one thing. But for traders, you’ll almost certainly see much lower NVDA prices over the next year or two.
On the date of publication, Ian Bezek did not have (either directly or indirectly) any positions in the securities mentioned in this article.
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.