Nvidia (NVDA -3.33%) has become a hot stock with investors who have sent its shares soaring 80% since the start of the year. Perhaps the company's long track record of stellar investment returns or its potential role in the growth of artificial intelligence has motivated buyers.
But the market often overdoes things. Nvidia's operating numbers may struggle to support the share price over the coming quarters. A closer look at the company shows some warning signs of potential trouble.
Here is why investors should resist the FOMO and rethink putting new money into Nvidia today.
A picture can say a thousand words
There are many reasons to like Nvidia over the long term. It's a world leader in discrete graphics processing units, which are used in various applications that require high computing power. Examples include gaming, cryptocurrency mining, data centers, and artificial intelligence. Additionally, the company is integrating software into its business, widening the scope of how its products are used.
However, Nvidia is ultimately a semiconductor company, and the industry has traditionally been cyclical. The business can boom when the economy is strong and dip when companies pull back their spending. Economists are widely expecting a recession in the coming quarters, and you can see clues of Nvidia's business slowing down if you look closely.
Below you'll see how Nvidia's revenue growth has slowed, then turned negative over the past four quarters. Meanwhile, inventories have grown by roughly $2 billion at the same time:
NVDA Inventories (Quarterly) data by YCharts
What does this mean? Nvidia is producing chips faster than it can sell, creating a pile of inventory on its books. Management might need to discount its products to move the inventory, which would pressure the company's profit margins.
Failure to clear an increasingly higher bar
Stock prices are essentially a game of expectations, meaning the market can react positively when companies beat expectations and negatively when they don't. How do you know what the expectation is? Consider a stock's valuation. For example, Nvidia's price-to-earnings ratio (P/E) values a company based on its earnings per share (EPS).
You can see below that Nvidia's P/E is at 155, well beyond its average over the past decade. In other words, investors are willing to pay more for Nvidia's earnings because they expect great performance from the company.
NVDA PE Ratio data by YCharts
But remember, Nvidia's revenue is shrinking, and margins could come under pressure if it needs to start discounting its growing inventory. That doesn't sound like a recipe for great operating results. If Nvidia's operating results disappoint Wall Street, investors could react by selling the stock. As they say, the higher the climb, the harder the fall.
What should investors do?
There's a case for selling the stock based on its eye-popping valuation, but I understand investors choosing to hold -- especially if you're sitting on shares bought years ago for far less. Nvidia's long-term future looks bright, and there will probably be another up-cycle down the road that could push Nvidia to new heights.
But if you're looking at buying shares for the first time, it could be a bad idea. We could be just entering a downturn in the economy, which could easily see the stock sold from its lofty levels down to a much more attractive price. In other words, there are more reasons for the stock to go down than to keep climbing. Some patience might give you a much better buying opportunity over the coming months.
