2023 could be dubbed the year of artificial intelligence (AI). Since the introduction of ChatGPT late last year, the world has been intrigued by recent developments in generative AI, which can create original content like music and poetry, summarize existing content, and even engage in human-like conversation.
Companies, realizing the potential implications, have been scrambling to adopt AI and integrate it into their own business systems. One of the biggest beneficiaries of this AI gold rush is Nvidia (NVDA 1.92%). While the semiconductor specialist is best known for the graphics processing units (GPUs) used to render lifelike images in video games, its chips are also the gold standard for AI.
The recent boom has sent Nvidia through the roof, with shares up 175% so far this year. The soaring stock price has value investors running for cover. Surprisingly, though, the stock is actually cheaper than before its monster rally. Here's why.
Nvidia DGX Grace Hopper 200 AI Supercomputer. Image source: Nvidia.
What caused the blistering rally?
It's no secret that while Nvidia's quarterly results were better than expected, they were still tepid at best. Revenue grew 19% year over year, while adjusted earnings per share (EPS) declined 20%.
The culprit? Nvidia's gaming segment continues to suffer the ill effects of the downturn. Faced with soaring inflation and rising interest rates, consumers have cut back on spending to make ends meet.
As a result, gamers have been hanging onto their high-end GPUs a bit longer instead of upgrading to Nvidia's latest and greatest. This penny pinching sent gaming revenue down 38% compared to its record-setting performance in the year-ago period.
Yet it was the performance of Nvidia's data center segment -- which includes chips used for AI -- that lifted the stock. Revenue rose 14% year over year to hit a quarterly record, driven by skyrocketing demand for processors used for AI.
While that performance was impressive in its own right, it was Nvidia's forecast that sent the stock into overdrive. Management's guidance called for revenue to increase 64% year over year in the current quarter, with a corresponding boost to the bottom line.
The stock is by no means cheap -- but it's cheaper
To understand this seeming contradiction requires a peak at Wall Street's expectations for Nvidia's performance over the coming year, in terms of its price-to-earnings (P/E) ratio.
Before Nvidia reported the results and delivered its blockbuster forecast, analysts' consensus estimate was calling for EPS of roughly $4.59. At the time, the stock was trading for roughly $302, or about 66 times next year's expected earnings. Fast-forward to today, analysts are now anticipating EPS of $7.75. At Tuesday's closing price of about $401, that's only about 52 times next year's expected earnings.
Is it cheap enough?
Value investors will argue (and rightly so) that the S&P 500 trades for roughly 18 times next year's earnings, a much more reasonable valuation -- but this can't be viewed in a vacuum. If the current AI boom continues, Wall Street is likely being too conservative with its expectations for Nvidia, resulting in another round of rising forecasts.
Even modest estimates for the potential opportunity represented by AI are eye-catching. Management consulting firm McKinsey conservatively values the market at between $3.5 trillion and $5.8 trillion annually, while Ark Investment Management has a much more bullish view, pegging it at roughly $14 trillion by 2030.
If Nvidia can capture even a small slice of that market, expectations for its growth may still be vastly underestimated.
