There’s one core reason to avoid Advanced Micro Devices (NASDAQ:AMD): valuation. AMD stock isn’t cheap. It trades at 54x forward earnings.
Admittedly, that multiple doesn’t sound all that high in the context of the current market. Companies with no profits at all are being valued at billions and billions of dollars. Still, for a semiconductor stock, 54x next year’s earnings (which, in this case actually means calendar 2021, to be clear) is unusual from a historical perspective.
But there’s one lesson that has held over and over again in this market. It’s a lesson I’ve tried to highlight numerous times of late. Lately, investors have not gone wrong in focusing on the quality of a company over the valuation of its stock.
That’s not to say that valuation doesn’t matter; it does. Nor is it to say that investors should just keep buying every growth name until the market decides otherwise.
Rather, the best companies can grow into steep valuations. AMD is one of those companies. And I expect fourth quarter earnings this week to remind investors of that fact.
No Longer Cyclical
Again, 54x earnings is a big multiple for a semiconductor stock, historically speaking. It really wasn’t all that long ago that chip stocks were almost cheaper than the rest of the market.
The core reason for that was that semiconductors were an inherently cyclical business. They weren’t necessarily cyclical in the macroeconomic sense like, for example, homebuilders. Rather, innovation drove demand, which improved pricing and profit margins.
Manufacturers would respond to those higher prices by ramping up supply. Almost invariably, they’d flood the market, prices would plunge, and profits would fall.
The same dynamic still holds in some pockets of the space, notably in memory, which is why it’s not a surprise that the biggest companies in that end market frequently look cheap from an earnings standpoint.
But AMD’s end markets aren’t dealing with that cyclical problem. They’re not going to for some time, either. Gaming demand certainly accelerated during the novel coronavirus pandemic, but it’s not going anywhere any time soon. Data centers are going to be built for years, if not decades, to cope with the massive explosion in usage. Even personal computers are hanging in better than expected.
AMD simply isn’t a cyclical company any more. And so AMD stock shouldn’t be treated as a cyclical.
Massive Growth Opportunities
Now, if AMD isn’t cyclical, the story gets a lot more interesting. Investors shouldn’t be looking at recent and near-term profit growth as a trend that’s likely to reverse in a few years.
And if that reversal isn’t on the way, 54x earnings is simply not all that expensive. Again, AMD is facing end markets that are going to grow at relatively rapid rates going forward. Meanwhile, the counterintuitive good news is that the company’s market share isn’t all that high.
That’s particularly true in gaming and datacenter, which are the two best markets. The combination of higher share in a growing market can lead to explosive top-line increases. Those increases, in turn, drive higher operating margins and thus accelerated increases in net income.
In PCs, meanwhile, AMD was a second-tier supplier only a few years ago that was mostly involved with cheap products. Thanks to its Ryzen line, that’s no longer the case. Ryzen beats rival products “in every metric that matters,” as a well-respected computer hardware reviewer recently put it.
So, yes, AMD stock is expensive. But 54x is a valuation the company can grow into. Bear in mind that AMD, even on an adjusted basis, lost 14 cents per share in 2016 and earned just 17 cents the following year. It has a real shot at nearing or hitting $2 in 2021.
Earnings Should Boost AMD Stock
Of late, investors have forgotten a bit about the good news surrounding the stock. AMD has traded sideways since late November. In fact, it’s flat compared to its brief highs back in early September.
The Q4 earnings report this week should change that. I firmly expect a blowout quarter. AMD’s core rival did well in the quarter, though not well enough to suggest it has retaken any market share.
More importantly, AMD’s manufacturing partner posted an absolute blowout earlier this month, and is betting some $28 billion on rising demand. It’s highly unlikely it would make that bet without AMD, a key customer, seeing strong demand and strong growth.
To be clear, I’m not saying AMD is a trade ahead of earnings. The case for the stock is based on its long-term growth potential. It’s just that earnings may remind the market of that potential and create a higher entry point by week’s end.
On the date of publication, neither Matt McCall nor the InvestorPlace Research Staff member primarily responsible for this article held (either directly or indirectly) any positions in the securities mentioned in the article.
Matthew McCall left Wall Street to actually help investors — by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. Click here to see what Matt has up his sleeve now. As of this writing, Matt did not hold a position in any of the aforementioned securities.