Nvidia (NVDA 3.65%) is spearheading the artificial intelligence (AI) revolution. The company's highly advanced processors are helping to power top AI applications, including ChatGPT, Dall-E, and Stable Diffusion, and surging demand for its products has also powered big gains for the company's stock. The processing leader's share price is now up roughly 166% across 2023's trading.
Will the incredible rally continue, or is the red-hot AI growth stock bound to cool off? If you're thinking about buying Nvidia stock or already own it in your portfolio, read on for a look at one green flag and one red flag that could impact the company's share price going forward.
Green flag: AI is set to transform Nvidia's business
After beating performance targets in the first quarter, Nvidia expects to grow sales by 53% on a sequential basis in the current quarterly period to reach revenue of $11 billion. Prior to the company's Q1 report and guidance, the average Wall Street target had called for $7.15 billion in sales in Q2.
In other words, Nvidia's guidance beat the average analyst estimate by roughly 54%. An explosion of AI-driven demand in the data-center market was the key factor behind the big beat, and it looks like it could lead to big margin improvements as well.
In the first quarter, the processing specialist recorded a non-GAAP (adjusted) gross margin of 67.1%. Even accounting for cyclicality, few hardware companies ever come close to posting that kind of gross margin. But Nvidia's profitability could actually climb substantially from current levels.
With guidance for an adjusted gross margin of 70% in the current quarter, the company is already forecasting a significant margin improvement this quarter. Believe it or not, the processing leader has catalysts that could make the picture even better.
Nvidia is gearing up to pursue a new growth driver: Artificial-intelligence-as-a-service (AIaaS). Thanks to its clear leadership position in high-performance graphics processing units and other advanced processors, the company has a foundation to build a software and AIaaS business component that turns into a substantial sales driver and is a major positive catalyst for margins.
Artificial intelligence is already spurring huge demand for hardware in the data-center segment, and the company now has a new performance driver emerging in the form of its services business.
Red flag: The valuation already has strong performance baked in
Nvidia is one of this year's hottest stocks. Whether it's completely justified or not, the company's valuation has undoubtedly gotten a boost from the hype surrounding artificial intelligence.
NVDA P/E Ratio (Forward) data by YCharts.
Priced at roughly 41 times this year's expected earnings and 51 times next year's expected profits, Nvidia's valuation already has some very strong performance baked into it. For a bit more context, take a look at the company's forward price-to-sales multiples.
NVDA P/S Ratio (Forward) data by YCharts.
Even with very strong margins, Nvidia has a highly growth-dependent valuation, trading at roughly 22.6 times this year's expected sales and 18.9 times next year's forecast revenue. These expectations open the door for significant valuation volatility.
Cyclical demand trends also historically had a big impact on the semiconductor industry, and it's possible that macroeconomic pressures will cause the company's performance to fall short of expectations. On a cyclical downswing, revenue and margins can decline substantially.
While the overall chip industry seems to be moving closer to enjoying secular growth trends now that a wider range of products and services depend on semiconductor hardware, Nvidia has a valuation that's more growth-dependent than most leading players in the industry. There's no doubt Nvidia is a great company, but the stock is priced at levels that make it risky as an investment.
Should you invest in Nvidia today?
Investors should be cautious about buying into stocks that are seeing huge rallies thanks to the latest hot trend on Wall Street. AI could wind up as this century's most important tech movement, but it's still important to weigh valuations for leading players in the space before going all-in on their stocks.
On the other hand, Nvidia has competitive advantages that could prove very difficult for competitors to disrupt, and the company looks poised to facilitate and benefit from the AI revolution. As impressive as the company's Q1 report and forward guidance were, they could be signs of a much bigger shift taking place at the company.
For investors looking to capitalize on artificial intelligence, Nvidia looks like a worthwhile portfolio addition. But given the recent hot streak for the stock, investors may be better served by dollar-cost averaging into the stock instead of amassing a large position all at once.
