Investing in the potential of artificial intelligence (AI) right now isn't easy. While there is a lot of hype and interest in the industry, there is also reason for caution. Many stocks can become overhyped and see their valuations skyrocket to unsustainable levels. When actual business results are examined, these stocks don't live up to expectations and their prices crash.
Trends like this also played out in the dot-com bubble in the early 2000s. Many current investors (like myself) weren't old enough to invest when that trend was in vogue. More recently, software-as-a-service stocks, cryptocurrencies, and metaverse-centric companies have all gone through their boom times, only to eventually see their prices crash back down to earth.
Keeping this real potential for a bust in mind, are there any AI stocks worth investing in long-term? Or is hype history about to repeat itself? Let's take a look at three AI-related stocks and see why one might want to be avoided right now while the other two have potential.
Nvidia will need unbelievable growth to justify its current valuation
One AI-related company to avoid at the moment is Nvidia (NVDA 5.88%). Looking at its stock performance in 2023, one might think that everyone has already declared this graphics processing unit (GPU) designer a winner in the AI race. While I agree that Nvidia is a likely winner and will see its business rapidly grow, it's hard to justify new investors buying the stock at its overinflated valuation. It trades well above its historical valuations in both price-to-sales (P/S) ratio and price-to-earnings (P/E) ratio.
NVDA PS ratio; data by YCharts.
The final push over the absurd valuation line came in the fiscal 2024 second-quarter guidance (for the quarter ending July 31) Nvidia management gave during its fiscal 2024 first-quarter conference call:
Total revenue is expected to be $11 billion, plus or minus 2%. We expect this sequential growth to largely be driven by data center, reflecting a steep increase in demand related to generative AI and large language models. This demand has extended our data center visibility out a few quarters, and we have procured substantially higher supply for the second half of the year.
That indicates year-over-year growth of 64%. Furthermore, management implies that this trend is sustainable over multiple quarters. But even if Nvidia can grow its revenue by 64% over the next 12 months, it will only bring its trailing-12-month revenue total to $43 billion. That values Nvidia stock at 23 times sales -- still above its long-term average of 17.
That's a lot of growth over the next year for an already sizable company, and it still doesn't return Nvidia to normal valuations. Should it repeat that same 64% growth rate over two years, the P/S ratio would sit at 14. So Nvidia would have to increase its revenue by 169% from today's levels and not gain a single dollar more in its stock price for the valuation to return to historical levels.
I'm not saying that Nvidia can't grow that much, but I am saying it's highly improbable. For this reason, I think it's wise to avoid Nvidia's stock.
But here are two other AI-related companies that are worth another look at the moment.
These two stocks are less overhyped than Nvidia
CrowdStrike Holdings (CRWD 1.52%) and Palantir Technologies (PLTR 3.18%) are two companies that market AI applications, and each heavily uses AI technology in its various software offerings. Each company also expects a strong year of business performance, although neither can match Nvidia's projected growth.
| Company | Full-Year Revenue Guidance | Growth |
|---|---|---|
| Palantir | $2.21 Billion | 15% |
| CrowdStrike | $3.02 Billion | 35% |
Data sources: Palantir and CrowdStrike.
Where these two stocks shine are their valuations, as each trades in a more palatable range than Nvidia, at least in comparison to their averages.
CRWD PS ratio; data by YCharts.
Now, 15 times sales isn't a historically cheap valuation for any company. So investors shouldn't think they are scooping these two stocks up for bargain prices. But because each is steadily growing and isn't starting from an absurdly high valuation (like Nvidia), the potential for future gains is still there.
Because of that, I think CrowdStrike and Palantir are better buys than Nvidia. While each company deserves further investigation into how AI is deployed throughout their products and what potential that brings for their future growth, the valuation levels do not automatically disqualify them from being purchased, unlike Nvidia.
