Investors who owned NVIDIA (NVDA -1.92%) for all of 2021 have looked like geniuses. The company's graphics processing units (GPUs) have been and remain in high demand in hot sectors like gaming, data centers, and artificial intelligence. The stock appreciated by 125% last year, crushing the broader market.
There's an investing philosophy that says that "winners keep winning," but while NVIDIA's business could keep growing at a rapid clip, the stock might disappoint investors in 2022.
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Share price gains have outrun revenue gains
The market's positive sentiment toward NVIDIA has been building gradually over the past several years -- for understandable reasons. The company's revenue has grown by 107% over just three years.
Its leadership position in the GPU segment has allowed it to capitalize on the growth of numerous applications that require heavy computing power -- among them, gaming, cryptocurrency mining, data centers, AI, and autonomous driving. NVIDIA has also expanded beyond its core hardware business, developing and tying software into its GPU products to offer more complete solutions to its clients.
However, its share price increases have steadily outpaced its revenue growth, and the gap widened throughout 2021. NVIDIA is now nearing nine-bagger returns in just three years.
As such, NVIDIA stock has been valued at a rising premium. It traded at a price-to-sales (P/S) ratio of less than 8 in 2019, but its P/S is approaching 31 today.
Can the stock support this valuation?
I think it's fair to argue that NVIDIA's higher valuation multiples are justified. Its revenue growth has dramatically accelerated over the past several years.
NVDA PS Ratio data by YCharts
Higher valuations typically are based on higher expectations from investors, so NVIDIA's business will need to support its current stock price with strong revenue and earnings growth. However, some of NVIDIA's growth in recent quarters may be related to the global chip shortage, which is pushing product prices higher as demand outstrips supply. In November, PC Magazine reported that the retail price of NVIDIA's RTX 3070 GPU rose 32% over the course of a year, from $569 to $749.
Such increases would undoubtedly help boost revenue growth, but selling more units is likely a more sustainable way for the company to boost its top line. When chipmakers bring more manufacturing capacity online, a return to more competitive pricing would naturally slow down the revenue growth unless the higher number of GPUs sold makes up the difference.
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More potential downside than upside
Investors must consider both the potential upsides and downsides of a stock when making buying decisions. Nobody can be sure what the future will hold for NVIDIA, especially in the face of today's inflation and supply chain challenges.
While NVIDIA supplies industries that could continue growing, its own revenue growth might slow, especially given the business world's version of "the law of large numbers," which explains that the bigger a company grows, the harder it is to grow at rapid percentage rates. NVIDIA could finish its fiscal 2021 with more than $26 billion in revenue, and it sports a massive $735 billion market cap.
Analysts seem to be factoring these concerns into their revenue estimates for the chipmaker. The consensus estimate is for 18% revenue growth in fiscal 2022 to $31.5 billion and 16.5% growth in fiscal 2023 to $36.7 billion. Those would be serious slowdowns compared to its gains in recent years.
If that scenario plays out, investors would likely find it difficult to justify the stock's elevated valuation, and we could see its price fall. Again, there is much to like about NVIDIA's long-term growth prospects, but investors might want to pump the brakes a bit. After its strong multiyear run, we could see NVIDIA cool off a bit in 2022.
