It's true that it often makes sense to hold on to shares of great companies, particularly when they're executing well. Sure, investors who take this approach may have to endure quite a bit of volatility, as a stock's valuation can get ahead of itself from time to time. But it's a simple way to only have to buy a good business once and profit from it over its lifetime. With this being said, a good rule of thumb is to consider selling a stock -- or at least significantly trimming the position -- when it becomes grossly overvalued. With graphics chip-maker Nvidia's (NVDA 4.35%) stock more than doubling year to date, has the stock gotten to the point that it is grossly overvalued?
To gauge whether or not NVIDIA shareholders should take some profits off the table today, let's take a look at two things: the overall market and NVIDIA stock specifically.
Signs of froth
First, investors should note that there are signs of exuberance in the pockets of the overall market, namely in tech. Signs of underlying froth in tech could pose a risk to Nvidia's stock price performance over the long haul. Note that even though the S&P 500 has risen 12% year to date, the Nasdaq Composite has soared a whopping 27%. Even more, the average price-to-earnings ratio of stocks in the Nasdaq 100 Index is now greater than 29 -- up from 26.5 this time last year and way above the average multiple of 18.7 for stocks in the S&P 500. In short, investors should tread cautiously right now when it comes to tech stocks. Not only have many of them seen extraordinary returns this year but some of their valuations have been pushed to levels that require very bullish long-term forecasts for their earnings growth over the next five years. There's little room for error.
Nvidia, which has contributed to some of the gains in both the S&P 500 and Nasdaq Composite, is arguably riding some of the bullish momentum in tech. With optimism in tech starting to look more like exuberance, however, it may be time to exercise some caution and take some profits in stocks that appear overvalued.
Is Nvidia stock overvalued?
Trading at nearly 200 times earnings, Nvidia stock definitely looks overvalued. Sure, the company is doing extraordinarily well, with net income rising 26% year over year in its most recent quarter. In addition, there's good reason to believe that it is positioned very well in several major growth markets, including autonomous driving, artificial intelligence, gaming, augmented and virtual reality, and cloud computing. But it's difficult to project earnings growth over the next five years and beyond since many of the technologies Nvidia makes products for are still in their early innings and are difficult to predict. With so much uncertainty, it's possible that long-term demand disappoints, expense growth is greater than anticipated, or -- even worse -- both of these narratives play out.
To be fair, it makes sense to pay somewhat of a premium for Nvidia stock considering how well the company is doing and how significant its growth opportunities are. But considering the uncertainty in the industries Nvidia operates in, a price-to-earnings ratio of 200 seems to simply be too risky.
So given Nvidia stock's huge run this year, it may be a good time for investors to exercise some caution and take some money off the table, deploying it into other high-quality companies trading at more reasonable valuations. While this could lead to an investor missing out on some upside if things go exceptionally well for Nvidia over the next five to 10 years, it would also likely help de-risk an investor's portfolio and possibly even help reduce volatility.
