NVIDIA (NVDA 4.00%) is enjoying strong demand for its graphics processing units (GPUs) across several markets, such as artificial intelligence, robotics, and 5G networking. While these areas present massive growth opportunities, investors are being asked to pay a steep price right now.
The shares currently trade at lofty valuation levels after a blistering run, so investors shouldn't expect the stock to deliver another 1,600% gain like it did over the previous five years. But NVIDIA still has lucrative opportunities emerging in software that could keep the business humming along.
How NVIDIA stock returned 1,600% in five years
NVIDIA has been on fire. Strong performance from its two largest segments -- gaming and data center -- resulted in revenue and earnings per share increasing by 53% and 73%, respectively, in fiscal 2021 (which ended in January).
It's not surprising that the stock price more than doubled over the last year, bringing its trailing five-year return to 1,610%. What fueled that impressive run was mostly NVIDIA's data center business. High growth in that segment not only caused revenue growth to accelerate but also caused NVIDIA's profits to explode, since data center products generate a higher gross margin than the rest of the business. This fueled stellar growth in earnings per share and wealth-building returns for investors.
The shares are now priced for perfection at an exuberant price-to-earnings (P/E) ratio of 90. That is more than twice the P/E level five years ago. Stocks follow earnings in the long run, but stock prices can't increase faster than the rate of business growth forever.
This doesn't mean NVIDIA can't perform well enough to send the stock higher from here, but the company can't afford a stumble either. In the near term, it is navigating through supply shortages of chips for gaming and data centers. While management believes they have enough supply to meet the demand for the full year, they will have to execute extremely well.
That said, let's look at why it might be worth buying shares at these levels.
Why it's worth paying up for NVIDIA stock
In my experience investing in growth stocks, it's usually worth paying up for great companies. I've learned to consider valuation loosely. The reason is that investors tend to underestimate how long a company can grow. This is especially true of high-growth companies like NVIDIA that have massive opportunities to expand.
Here are just a few examples of what NVIDIA is doing that speak to big return potential.
NVIDIA is starting to describe itself more as a platform company, not just a chip supplier. It now provides software tools, software development kits, and applications on top of the hardware (GPUs) to allow enterprises to customize the chip to their specific needs.
For example, NVIDIA AI Enterprise is a software platform that significantly reduces the time it takes for an organization to develop artificial intelligence solutions in the data center and cloud. NVIDIA offers this software with a perpetual license fee charged for each CPU socket, and it also comes as a subscription service. Management sees NVIDIA AI Enterprise as a multi-billion-dollar opportunity.
Another catalyst that might be underestimated by investors is the well-publicized deal to acquire Arm Holdings from Softbank Group (SFTB.Y 0.44%) (SFTBF -0.10%) for a total transaction value of $40 billion. It's currently going through intense scrutiny by regulators in various countries. The reason is that NVIDIA stands to gain a dominant position in the global semiconductor industry since Arm's chip design is used in 90% of smartphones worldwide. Arm will also strengthen NVIDIA's position in other high-growth markets, including Internet of Things, cloud, self-driving cars, and robotics.
Still, some investors might be losing hope that the deal will go through. Citi analyst Atif Malik sees just a 10% chance that NVIDIA walks away with Arm. On the flip side, NVIDIA CEO Jensen Huang recently stated that the deal is still on track to be completed by 2022.
At this point, a completed transaction could bolster NVIDIA's share price, since there appears to be a diminishing expectation that the deal will happen at all. If NVIDIA wins Arm, management expects the deal to be immediately accretive to NVIDIA's adjusted gross margin and earnings per share.
NVIDIA's future is wide open
Even if the Arm deal fails to get approval, NVIDIA is well-positioned for a bright future. It's in the process of widening its competitive moat, creating a stickier ecosystem of hardware and software tools that should cement its future growth trajectory. Management previously estimated its total addressable market in data center at $100 billion, and that was before the recent unveiling of "Grace" -- NVIDIA's first CPU designed for the world's most powerful computers.
NVIDIA is an essential technology provider for the future of computing across major sectors like healthcare and transportation. That might be enough reason to at least start a small position in the stock even at these high valuation levels.