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Is NVIDIA a Buy?

By John Ballard – Aug 1, 2020 at 10:48AM

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This chip company is experiencing tremendous momentum, but the high valuation should give investors pause.

The COVID-19 crisis has not slowed down NVIDIA (NVDA -1.51%) as its stock is up 78% year to date, following back-to-back quarters of robust operating results. NVIDIA's gaming segment revenue increased 27% year over year in the most recent quarter, but it's the data center business that's in the spotlight after posting growth of 80%. 

NVIDIA's momentum should continue in the near term. Its new Ampere graphics processing unit (GPU) for data centers is currently in production. NVIDIA also recently completed the acquisition of data center networking provider Mellanox, which is expected to be accretive to NVIDIA's margins and profits in the next quarter. But investors have to weigh these strengths against a valuation that already factors in a lot of upside.

A computer chip on a circuit board.

Image source: Getty Images.

Data center spending on the rise

NVIDIA's new Ampere GPUs are a significant jump in performance over the previous generation, and it's driving the strongest demand NVIDIA has ever experienced in the data center segment. The A100 GPU based on Ampere was just announced in May and is in full production. It is up to 20 times faster for artificial intelligence workloads. Major cloud providers are adopting the chip, which contributed to NVIDIA's strong fiscal first quarter.  

During the latest conference call, CEO Jensen Huang said, "The demand is fantastic. It is the best ramp we've ever had." The demand was strong enough to send data center revenue above the $1 billion level for the first time. The segment made up 37% of NVIDIA's top line in the first quarter, up from 29% in the year-ago period.

Moreover, Huang believes the demand for accelerated cloud computing, which is underpinning NVIDIA's data center growth, is just getting started. As Huang explained during the May conference call, accelerated cloud computing is currently a $100 billion industry and will grow to $1 trillion. 

"I think that accelerated cloud computing is a movement that is going to be a multi-year, if not a decade-long, transition," Huang said. NVIDIA has plenty of secular demand fueling its growth, but given the stock's recent run, it might not be a bad idea to wait until after the next earnings report before thinking about buying shares.

Priced to perfection

The stock looks expensive at a trailing price-to-earnings valuation of 79. However, analysts' earnings expectations for the next year bring the forward P/E down to a more hospitable 51, but that's still high for a semiconductor company.

NVIDIA is certainly delivering the goods on the bottom line. Non-GAAP (adjusted) earnings per share jumped 105% year over year in the last quarter, and analysts are forecasting adjusted EPS growth of 41% for fiscal 2021. Those stellar growth rates can justify the valuation now, but there are risks to buying chip stocks at peak valuations.

Demand for semiconductor companies can swing unexpectedly, as NVIDIA's data center segment did last year when hyperscale computing customers pulled back on spending to use up excess capacity before buying new GPUs. As a result, NVIDIA's data center revenue increased just in fiscal 2020, which caused the stock to crater early in 2019. The stock didn't recover until there were signs of a rebound in that segment.

NVDA Chart

Data by YCharts.

I own shares I intend to hold for many years. NVIDIA's long-term growth looks bright, given the secular demand trends from cloud computing. Plus, growth in the video game industry should support rising sales of gaming graphics cards over time. NVIDIA also has upside in the self-driving car space, where it just signed a potentially lucrative deal with Mercedes-Benz.

But if I were starting a new position, I would wait for a better entry point. There are plenty of other good options in technology, especially for investors looking to ride the growth of cloud, such as Microsoft, which offers solid prospects but at a much lower valuation than NVIDIA right now. 

NVIDIA is a solid growth stock to consider for your nest egg, but at these lofty levels, there is no harm in waiting a few weeks until NVIDIA reports its fiscal second-quarter earnings. There's always the chance NVIDIA may report results that don't quite meet Wall Street's high expectations, which should provide the opportunity to scoop up shares at a discount.

Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. John Ballard owns shares of Microsoft and NVIDIA. The Motley Fool owns shares of and recommends Microsoft and NVIDIA and recommends the following options: long January 2021 $85 calls on Microsoft and short January 2021 $115 calls on Microsoft. The Motley Fool has a disclosure policy.

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