You’d be hard pressed to find a hotter stock than Nvidia right now.
From early 2023 to June 8, the stock has returned more than 163% – a meteoric rise that has the chipmaker flirting with a market capitalization of $1 trillion.
Currently, only four companies can claim that the total value of their outstanding shares exceeds $1 trillion: Apple, Microsoft, Google parent Alphabet, and Amazon.com.
Nvidia differs from those companies in one key way: valuation.
Valuation is a general term that generally refers to how the market assesses the value of a business. This is usually measured by comparing a company’s stock price with one of its underlying financial measures such as earnings, revenue, or cash flow.
When you buy a stock, you are buying a share of a going concern that you expect to grow in the future, and stock prices generally reflect that potential growth. Essentially, investors are willing to pay more for a company than it is worth today.
One way to measure this phenomenon is to look at the company’s share price against a fundamental measure, such as earnings or sales. If a company makes $1 in earnings per share and trades $10 per share, it is said to have a price/earnings multiple of 10.
How does a particular stock’s multiple compare to its own history (has it ever had such a high multiple?), peer companies (do tech companies tend to have high multiples? ) and the stock market as a whole (how does this company compare to the average S&P 500 company?) determine whether investors view a stock as overvalued or undervalued.
Warren Buffett looks for stocks that are trading at a low price relative to their underlying value – a strategy known as value investing. Other investors are willing to pay a large premium for a company from which they expect explosive growth.
Now back to Nvidia and the trillionaires.
Nvidia shares currently trade at 204 times the company’s earnings per share. That’s lower than Amazon’s 296 multiple, but Amazon has always been an outlier in this regard; the retail giant is raking in tons of cash that it could convert into revenue if it wanted to. Microsoft is trading for 35 times earnings, Apple for 31 times, Alphabet for 27.
Compare stock prices to sales and the difference becomes clearer. Amazon trades at 2.4 times sales, roughly in line with the average for S&P 500 companies. Alphabet’s price-to-sales ratio is 5.6, Apple’s is 7.5, and from Microsoft of 11.7.
What Nvidia’s high valuation means for investors
Based on earnings and sales, Nvidia is priced higher than the four largest stocks in the market.
That doesn’t mean you shouldn’t buy it or that you should sell it if you already own it. Instead, any potential investor in Nvidia should do two things, investment experts say.
1. Examine the hype
Nvidia is not a stock of memes. Investors are piling in because they believe in the fundamentals of the chipmaker’s business.
Nvidia is the dominant player in graphics processing units – an essential component for running AI in the cloud. Tech investors have seen this as a compelling opportunity for years, and Nvidia got a boost when OpenAI launched viral chatbot ChatGPT earlier this year.
“It was an iPhone moment,” says Angelo Zino, senior industry analyst at CFRA. This forced companies across a wide range of industries to rethink how and how much they were going to invest in AI.
“So it’s very difficult to look at these conventional valuation metrics when assessing the size of this opportunity,” adds JR Gondeck, Lerner Group Managing Director at Hightower Advisors.
Basically, investors are paying big now in the belief that the company’s fundamentals will eventually justify the price, and even make it look cheap in hindsight.
“Given the growth opportunities we see going forward, we think the multiple is quite reasonable,” Zino says.
2. Prepare for volatility
If you believe in the long-term potential of a hyper-growth stock like Nvidia, you need to be prepared to endure steep declines in the value of your investment to reap the rewards, investment professionals say.
During market sell-offs, the companies trading at the highest multiples are often the hardest hit. When investors are betting heavily on a company’s future and that future suddenly looks bleaker, things can get scary in a hurry.
“No tree grows skyward,” says Gondeck. “You look at Apple, which recently hit an all-time high, and there were a lot of entry points along the way.”
Of course, these are just “entry points” – or buying opportunities – in hindsight. If you’ve owned Apple stock for decades, you’ve probably earned a pretty penny. You also experienced two drops of more than 80%, between 1991 and 1997 and between 2000 and 2003.
“If you’re a long-term investor in Nvidia, there’s going to be a lot of volatility along the way,” Zino says.
To prevent this kind of decline from derailing your portfolio returns, create a core portfolio of broadly diversified exchange-traded funds and mutual funds, finance professionals say.
And keep your individual stock bets in a relatively small corner of your portfolio. If you make the right choice, it’s the icing on the cake for your portfolio’s performance. Otherwise, you are still theoretically on track to achieve your financial goals.
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Check: Nvidia is worth nearly $1 trillion – here’s how much you’d have had you invested ten years ago