NVIDIA Stock: Coming Back Down To Earth (NASDAQ:NVDA)

Article Thesis

NVIDIA Corporation (NVDA) is a strong company, but investors should consider valuations before buying into any stock. The metaverse could allow for solid market growth potential, but it seems unlikely that metaverse spending by Meta Platforms (FB) and others will have a huge impact in the near term. The expected business growth rate is not overly high going forward, compared to how NVIDIA grew in the past. On top of that, rising interest rates are a key risk for NVIDIA due to its high valuation. Shares have come down considerably from the highs of more than $340, but shares are still pricy and I would not be surprised to see shares remain under pressure going forward.

The NVIDIA Bubble

NVIDIA Corporation has been a strong performer for years, but in late 2021, its shares exploded upwards:

Shares rose to as much as $346, which brought NVIDIA’s earnings multiple up to more than 100 for a short period of time. That was, of course, not reasonable for a company that was already valued at several hundred billions of dollars and that was expected to deliver compelling, but not spectacular growth in the future (according to the Wall Street consensus). Still, with money still being ultra-cheap and with the metaverse being in everyone’s mind for a while, NVIDIA was bid up to extraordinarily high levels.

That did, of course, not end too well, as all bubbles eventually burst. In NVIDIA’s case, shares peaked in fall 2021 and have declined meaningfully since — a drop from $340 to $220 has destroyed about $300 billion of market capitalization.

How Expensive Is NVIDIA?

The best way to gauge whether NVIDIA is expensive today is to look at its current valuation relative to how the company was valued in the past, I believe:

Note: PE ratio (forward 1 year) refers to the expected earnings multiple for the upcoming fiscal year, which starts in February 2022 and runs through January 2023.

We see that NVIDIA is valued at 44x next year’s expected net profits right now. We also see that the earnings ratio for the upcoming fiscal year was as low as 25 in spring 2021, which indicates that shares were way cheaper less than a year ago. On the other hand, we also see that the earnings multiple for the upcoming fiscal year was higher than 60 for a short period of time in fall 2021 — compared to that, they have become significantly cheaper. When we compare the current valuation to how NVIDIA was valued in the last 5, 7, and 10 years, we see that the valuation used to be higher, on average, over the last five years. At the same time, the 10-year median earnings multiple is significantly lower at 34.

When we compare NVIDIA’s current valuation to past valuations, we have to consider a couple of things, however. First, NVIDIA’s growth outlook today is different compared to five or ten years ago. Back then, NVIDIA was a way smaller company, and doubling the revenue was a way easier task compared to today. We see this when we take a look at NVIDIA’s forecast for its Q4 results: The company expects revenues at $7.4 billion, which indicates 3% quarter-to-quarter growth. This is significantly less than the growth rate of 9$, 14%, and 14%, respectively, during the previous three quarters. Clearly, growth has been decelerating, which suggests that valuations should decline as well, all else equal. Valuations should also always be seen relative to where interest rates stand, and those are poised to increase massively this year. Bank of America (BAC), for example, expects as many as seven rate hikes this year alone, which would lift the Fed funds rate to 2% — way more than the average over the last decade:

Apart from a short period of time in 2018 and 2019, the effective Federal funds rate always was below 1.5% in the last decade. Most of the time, it was close to zero. If interest rates are meaningfully higher in the future — which is expected by most experts — then valuations for all equities should compress, all else equal. If the Fed funds rate rises to 3%, for example, it would be way higher than at any point over the last decade — the historic median earnings multiples for NVIDIA would likely not be too relevant in that case. I do thus believe that investors should reasonably assume a lower future earnings multiple for NVIDIA’s shares, based on the lower relative growth rate (more on that later) and due to the interest rate environment which will not be very generous for expensive growth stocks.

Growth Outlook And What It Means For NVIDIA’s Shares

NVIDIA will earn about $4.30 during the current fiscal year and we should get the results for that in the coming weeks. For the upcoming fiscal year, which will end in January 2023, analysts are predicting earnings per share of $5.20. This equates to ~20% growth versus the previous fiscal year — compelling growth, but not outstanding. Over the last couple of years, NVIDIA’s growth used to be higher.

This is partially the result of the law of large numbers, which dictates that relative growth has to slow down eventually — no company can grow at a massive rate forever. On top of that, some end markets aren’t especially strong any longer. NVIDIA’s chips are, for example, used in crypto mining. Bitcoin (BTC-USD) can’t be mined effectively with GPUs, but other cryptocurrencies, including Ethereum (ETH-USD), can be mined using NVIDIA’s GPUs (or those of its peers). When cryptocurrencies ran up over the last two years on the back of ultra-lose monetary policy and massive fiscal stimulus, mining Ethereum and other cryptocurrencies became highly attractive, which led to increased demand for some of NVIDIA’s products. With cryptocurrencies slumping in 2022, however, on the back of a more restrictive monetary policy, crypto mining has become less attractive. Miners will most likely withhold spending large amounts of money on new mining equipment, which is why GPU demand from the crypto community should decline significantly this year (and possibly beyond). We have seen in the past that this can have a large impact on NVIDIA’s results:

When cryptocurrencies declined to multi-year lows in late 2018 and early 2019, NVIDIA’s revenues took a hit, both on a quarter-to-quarter basis, and on a trailing twelve months basis. NVIDIA is thus not insulated from how cryptocurrencies are doing. The company is larger and more diversified today, which is why I do not believe that revenue on a company-wide basis will decline going forward. Still, there should be a negative impact from weaker crypto pricing, and that could lead to revenue growth coming in below expectations.

It also looks unlikely that the Arm acquisition will be completed (although there is no definitive result yet). This will not be a company-breaking issue, but still, management has pursued this acquisition because they saw a strategic rationale for it. If the acquisition does not happen, that naturally means that NVIDIA can’t evolve in the way management wanted the company to evolve, as Arm was a part of that strategy. It is also noteworthy that NVIDIA will lose about $2 billion it already paid, which includes a $1.25 billion breakup fee. This will not cause any financial troubles at NVIDIA, but it is, of course, a negative.

In the long run, the semiconductor industry benefits from strong growth tailwinds. NVIDIA is well-positioned to capitalize on them in several markets, including gaming, autonomous driving, AI, and others. The metaverse is/was seen as another major growth driver for NVIDIA, which is part of the explanation for the steep share price rise in late 2021. I do believe, however, that investors might be reading too much into the metaverse’s potential — there are still way too many unknowns. It is also noteworthy that many other metaverse players, such as FB or Microsoft (MSFT), trade at huge discounts compared to how NVIDIA is valued:

Meta’s enterprise value to EBITDA ratio is just 12, that of Microsoft, seen by many as the leader in the “business metaverse”, is 23. NVIDIA, for comparison, trades at 50x EBITDA — a massive premium compared to the other two. NVIDIA can only have massive metaverse potential if other companies do so, too. If the market is not pricing in extreme growth at Microsoft, Meta, and others, why should NVIDIA deserve a huge valuation premium due to future metaverse tailwinds that are hard to quantify? I do not believe that, at the current valuation, NVIDIA is an especially attractive metaverse play. It is also noteworthy that software companies, such as Meta and MSFT, could be advantaged in a future growth market such as the metaverse, due to their generally stronger margins and stronger brands, compared to a hardware supplier such as NVDA.

It is possible that my current estimates are wrong. Potential reasons for NVIDIA performing better or worse than expected include the following: A steep recovery in crypto markets, which is, I believe, unlikely due to interest rate headwinds, but which is not impossible. In that case, GPU demand should be stronger than expected and NVIDIA could be more profitable than forecasted today. It is also possible that NVIDIA will be less profitable than what I do forecast today, e.g. due to more aggressive pricing by Taiwan Semiconductor (TSM) and other foundries. TSM has already hiked prices significantly last year and might do so again in order to boost their own margins. Since NVIDIA is reliant on foundries, it might see its gross margin (which is strong right now, at around 65%), come under some pressure in the future. Last but not least, NVIDIA is exposed to regulation in the autonomous driving space. If regulators move against self-driving…