Investing in AI stocks is the latest trend, but it's not for every investor. Over the past few years, investors (including myself) have been burned by hot trends like work-from-home or metaverse-focused stocks and sustained painful losses from some companies.
Applying this knowledge to other investment trends can keep you safe during this time of AI hype. So before you consider investing in an AI company, consider these topics.
1. Is the valuation right?
Valuation is a key subject, as even the best company bought at the wrong price can be a disaster. When assessing valuation, I always ask: "What kind of growth must this company sustain for this valuation to make sense?" Applying this to popular AI stock Nvidia (NVDA 6.18%) is a worthy exercise, as it is a chief culprit in overpaying for a company that will significantly benefit from AI rollout.
At 40 times sales, Nvidia trades higher than most stocks' price-to-earnings (P/E) ratio. Should Nvidia regain its peak profitability of a 38% profit margin, this would imply Nvidia trades at 105 times earnings. However, Nvidia is nowhere near its peak profitability, although this should improve in the coming quarters thanks to its impressive growth forecast.
Should Nvidia double its revenue, that only reduces its P/E ratio to 53, still an expensive figure. Additionally, Nvidia would need to sustain that revenue level for the valuation to make sense, and that's not guaranteed to happen once data centers meant for powering AI are built out.
Valuation should always be considered when purchasing a stock, but it becomes even more critical when a massive amount of hype surrounds it. By doing a quick gut-level check, you can determine if a stock is even worth considering.
2. Is the time right?
After passing the valuation test, it's OK to ask: "Is this AI stock good for me in my current situation?" If you're a young investor with a long investment horizon, this answer is likely "yes." However, investing in a volatile industry may not be the right choice if you're nearing or already in retirement.
Although there's a ton of talk about how AI will change the world, there's no guarantee of its overall effect. Gartner has a visual known as the "Gartner Hype Cycle," which talks about how people view technology as it becomes popular. In my opinion, we're still on the roller coaster up to the peak of inflated expectations.
Image source: Gartner.
The key is to find a reasonably priced company that can survive into the plateau of productivity, where massive investment gains can be seen. If you don't have the patience or time horizon to see an AI investment through to that end, then maybe investing in AI isn't a smart decision.
3. Is AI an actual influence on this business?
How many companies touted their "metaverse" aspirations in late 2020, and how many are still pursuing that goal? This same concept applies to the blockchain, connected home, or even 5G. Many companies discussed these topics to satisfy shareholders during presentations or conference calls, but nothing ever came to fruition.
When considering an AI stock, think about if AI is a game-changer or just a flash in the pan. While large language model (LLM) chatbots are all the rage, are they necessary for every facet of life? Probably not.
Consider companies like CrowdStrike (CRWD 2.03%) or Palantir (PLTR 3.73%), which utilize AI at their core to power machine learning programs that can process mountains of data to perform a task without human intervention. Additionally, advertising-based companies like Alphabet (GOOG 9.96%) (GOOGL 10.22%) and Meta Platforms (META 0.43%) are developing AI models to assess an ad viewer better and create custom ads tailored just to the user.
All four companies pass the valuation test and consider AI an actual business driver. While Nvidia passes test No. 3 with flying colors, it horribly fails the first test, making it a stock worth passing on.
If you're considering an AI stock, ask yourself these three questions. This should help weed out some imposters and leave them with genuinely good AI investments.
