Wall Street got jittery last week as Wedbush Securities analyst Matt Bryson downgraded Nvidia (NVDA -2.81%) stock from outperform to neutral on Friday, Nov. 6, citing the company's sky-high valuation.
Bryson admitted that he doesn't see any negative factors affecting Nvidia and remains positive about the company's prospects. However, he added that he doesn't see any justification for the rich multiples the stock is trading at. Interestingly, the Wedbush analyst raised his price target on Nvidia stock from $220 to $300.
It's worth noting that Nvidia stock has shot up nearly 133% in 2021, so it seems analysts are being cautious going into the company's fiscal 2022 third-quarter earnings report, which is set to be released after the bell on Nov. 17.
If Nvidia fails to outperform the high expectations it has set for itself -- or if the semiconductor shortage messes up its near-term guidance, as we've seen happen to other chipmakers -- then the stock could crash, and shareholders might lose some of the terrific gains they've scored this year. But a stronger-than-expected performance could send Nvidia stock soaring and make it more expensive.
So what's the best approach to Nvidia stock before its upcoming earnings report -- buy, hold, or sell? Let's try to answer that question.
Reasons to sell
Nvidia's valuation is one big reason why investors may want to sell shares before earnings. The stock is trading at 109 times trailing earnings, which is nearly double its five-year average price-to-earnings (P/E) ratio of 55.9. The current forward P/E of 65 is also on the higher side, compared to Nvidia's five-year average forward earnings multiple of 39.
The price-to-sales ratio of 35 is also quite expensive when we consider that Nvidia has traded at an average sales multiple of 15.6 over the past five years. The S&P 500, in comparison, has a P/E ratio of 28.7, a forward earnings multiple of 22.4, and a price-to-sales ratio of 3.2. To justify these multiples, Nvidia needs to smash expectations when it releases its results. A weaker-than-expected performance due to unforeseen circumstances may set alarm bells ringing and cause the stock to drop.
For instance, Nvidia CEO Jensen Huang recently pointed out that the chip shortage is likely to continue into 2022. Several companies have been unable to fulfill orders as the semiconductor shortage has restricted their ability to produce goods. Apple, for example, lost $6 billion worth of sales last quarter due to supply-chain challenges, and the iPhone maker expects similar problems to cause a bigger revenue loss this quarter.
This is despite the latest iPhone models being in great demand. Similarly, demand for Nvidia's graphics cards continues to exceed supply. But if the company can't make enough chips, its sales may suffer, and investor confidence may take a hit. There has been a hint that the chip shortage may be affecting Nvidia's graphics card sales, which may be a concern for investors given the company's rich valuation.
Reasons to hold
Shareholders who've enjoyed terrific gains in Nvidia over the past few years may not want to sell despite its rich valuation, given its history of delivering outstanding growth quarter after quarter.
Nvidia has consistently exceeded Wall Street's expectations, as the demand for its cards used in personal computers, data centers, and other fast-growing areas has been booming. Its earnings have comfortably exceeded consensus estimates over the past four quarters. The company's revenue, earnings, and margins have been heading north at a nice pace. So for many investors, selling a hot stock that they'd have happily bought at a cheaper valuation earlier may not be the right move.
Nvidia is expected to deliver $6.8 billion in revenue for the fiscal third quarter, which would be a 44% increase over the year-ago period. The company's earnings are expected to jump from $0.73 a share last year to $1.11 per share in Q3, an increase of 52%. History shows that Nvidia's actual results usually exceed guidance, while the outlook trumps Wall Street's expectations.
A similar story could unfold once again when Nvidia releases its results, considering its dominance of the graphics card market. The chipmaker controls 83% of the market for PC (personal computer) graphics cards, according to Jon Peddie Research, while Nvidia's share of the data center graphics processing unit (GPU) market was over 80% in 2020. As the global GPU market is expected (per a third-party estimate) to grow nearly tenfold over the next seven years, buying Nvidia seems like one of the best ways to tap into this terrific opportunity, given its solid market share.
That's another reason that longtime Nvidia shareholders might like to hold on to the stock no matter how its upcoming earnings turn out: The company seems built for long-term growth. This also brings us to a reason that investors on the hunt for a growth stock may want to buy Nvidia despite its expensive valuation.
Reasons to buy
We've seen that Nvidia dominates the graphics-card market, which is set for rapid growth in the long run. As the company gets 83% of its revenue by supplying graphics cards used in data centers and gaming computers, we can assume that its biggest end markets will continue to drive rapid growth in Nvidia's top and bottom lines.
However, new investors who are eyeing Nvidia stock have more reasons to be bullish about the company's prospects. For example, Nvidia will expand its addressable market in the data center business with the launch of a central processing unit (CPU) titled Grace in 2023. This move will help Nvidia enter the server-processor market, which is expected to hit $19 billion in revenue by 2023.
Meanwhile, Meta Platforms' digital environment -- or metaverse -- is expected to add another $10 billion to Nvidia's addressable revenue opportunity over the next five years, according to estimates by Wells Fargo. Also remember that Nvidia has built up a strong pipeline of design wins in the automotive business that could be worth more than $8 billion.
All of this indicates that Nvidia is looking to push the envelope further and enhance its prospects in the long run. So it wouldn't be surprising to see the company's earnings grow faster than analysts' expectations of 32% annually for the next five years as more catalysts come into play. That's why anyone looking for a top growth stock right now may want to consider buying Nvidia, as stronger-than-expected quarterly results could inflate the chipmaker's valuation once again.