3 Hot Stocks That Could Live Up to Their Lofty Valuations

The stock market is up strongly this year with the help of multiple tailwinds, including cooling inflation, an easing of Federal Reserve interest rate hikes, and a resilient U.S. economy, among other things. So far in 2023, the S&P 500 index has gained nearly 15%.

The Nasdaq Composite logged even stronger gains of 28.7%, driven by a solid rally in technology stocks thanks to new catalysts such as artificial intelligence (AI). The investor enthusiasm over the potential of AI is part of why Nasdaq components like Nvidia (NVDA 1.69%), Meta Platforms (META 2.26%), and Tesla (TSLA 3.91%) have shot up remarkably in 2023. Not surprisingly, all three stocks now trade at lofty valuations.

A closer look at their businesses indicates that these three stocks have what it takes to justify their rich valuations and deliver robust growth. Let's see why that might be the case.

1. Nvidia

Nvidia stock tripled its value so far in 2023 and now trades at a whopping 228 times trailing earnings. That multiple is way higher than the company's five-year average price-to-earnings ratio of 73, and it's significantly higher than the Nasdaq-100 index's trailing earnings multiple of 30. However, Nvidia's forward earnings multiple of 55 points toward a potential big jump in the company's earnings over the next year.

According to consensus estimates, Nvidia's earnings are expected to jump to $7.94 per share in the current fiscal year from $3.34 per share in fiscal 2023 (ended Jan. 29). What's more, the company's earnings could jump to $11.39 per share in fiscal 2025, which would be a 43% increase over the current year's estimated earnings.

What's more, Nvidia's revenue in fiscal 2026 is expected to jump to $71 billion, compared to $27 billion in fiscal 2023. There is a straightforward reason why analysts expect such outstanding growth from Nvidia: AI. The company estimates $11 billion in revenue for the recently concluded second quarter of fiscal 2024, which would be a sequential increase of 52% compared to its fiscal Q1 revenue.

Nvidia CFO Colette Kress said on the company's May earnings conference call that "generative AI drove significant upside in demand for our products." CEO Jensen Huang, on the other hand, said that the company is "significantly increasing our supply to meet surging demand." Nvidia's data center graphics cards are ruling the roost in AI chips, as they are capable of training complex AI models thanks to their massive computing power.

This is evident from the company's market share of 80% to 95% in data center chips, according to third-party estimates. Looking ahead, Nvidia is expected to maintain its dominant share in AI chips. Mizuho analyst Vijay Rakesh estimates that the company could control 75% of this market in 2027, which could translate into massive AI-specific annual revenue of $300 billion. For comparison, Nvidia is expected to generate $25 billion to $30 billion in AI revenue this year.

All this indicates that Nvidia could remain a hot growth stock in the long run and justify its lofty valuation with terrific AI-powered growth.

2. Meta Platforms

Shares of social media giant Meta Platforms have shot up a whopping 145% so far in 2023 after having a terrible time last year. The stock benefited from a turnaround in its fortunes this year, delivering solid earnings growth and a nice improvement in its top-line performance.

The red-hot rally has made Meta stock expensive. It is now trading at 36 times trailing earnings and 6.7 times sales, both of which are higher than the S&P 500's earnings and sales multiples of 20 and 2.5, respectively. But Meta could live up to these relatively expensive multiples thanks to an improvement in the digital ad market's prospects, as well as its focus on integrating AI into its solutions.

The company ended 2022 with a 1% decline in revenue to $116.6 billion, while adjusted earnings were down 38% to $8.59 per share. Both metrics are expected to improve nicely in 2023 and beyond.

Source: YCharts. EPS = Earnings per share. YOY = Year over year.

What's more, Meta's earnings are expected to grow at an annual pace of almost 31% for the next five years. It wouldn't be surprising to see Meta deliver such solid growth in the future, as global digital ad spending is expected to increase from $550 billion in 2022 to $871 billion by 2027.

Meta generated ad revenue of $113.6 billion last year, accounting for 97% of its top line. Based on eMarketer's estimate of the size of the digital ad market last year, Meta controlled just over 20% of this market. A similar market share in 2027 could push Meta's ad revenue to almost $180 billion, which would be a 60% increase over last year.

But it is worth noting that Meta could corner a bigger share of this market thanks to AI. The company is already benefiting from AI algorithms on Facebook and Instagram that suggest video content to users, leading to an improvement in monetization. It is now looking to add new AI-enabled features that will help improve ad performance for marketers and make it easier for advertisers to create, run, and optimize campaigns with the help of AI.

In all, Meta has solid catalysts that are likely to help the stock maintain its impressive momentum and justify the valuation it is trading at, suggesting that investors would do well to hold this tech stock in their portfolios even though it has gained big time in 2023.

3. Tesla

Tesla stock's 94% jump in 2023 means that it now trades at 68 times trailing earnings. The price-to-sales ratio of 9 is also on the expensive side. A closer look at Tesla's performance in the second quarter of 2023 suggests that it may struggle to justify its rich valuation.

The electric vehicle (EV) specialist's margins shrank as Tesla enacted vehicle price cuts as it looks to move more units. The move hasn't gone down well with investors, as the stock fell 10% after the company released its earnings on July 20. The stock is down 15% in the past month. Tesla's gross profit margin has declined steadily since the first quarter of 2022, when it stood at 30%, to 18.1% in the previous quarter. The margin challenges are likely to continue, as Tesla recently reduced prices once again in China.

This explains why Tesla's earnings are expected to drop to $3.44 per share from $4.07 per share in 2022. However, things are expected to improve beginning next year.

Data by YCharts.

What's more, the company's revenue growth is also anticipated to remain healthy.

Data by YCharts.

The projections suggest that Tesla may eventually be able to justify its rich valuation, and that wouldn't be surprising given that it operates in a market that's built for growth. Goldman Sachs estimates that overall annual EV sales could go up to 73 million in 2040 from 2 million units in 2020. Even then, there would be a lot of room for growth in EV sales post-2040, as these vehicles are expected to account for 61% of global car sales at that time.

Tesla is focused on making the most of the long-term opportunity on offer by increasing its production capacity. The company reported an installed annual vehicle production capacity of just over 2 million units in the second quarter, a number that could rise further given that its Cybertruck production line is currently in the tooling phase.

The Cybertruck is expected to go into production later this year, which means that it will now be able to tap another lucrative niche. Tesla is likely hoping that the Cybertruck could help it crack the pickup truck market in the U.S., which is expected to generate over $74 billion in revenue this year. Also, Tesla is looking to bring new production facilities online in international markets such as Mexico, where the company is reportedly looking to build a plant with an annual capacity of 2 million units.

Additionally, Tesla could unlock new revenue opportunities with the help of AI. So the recent downturn in Tesla stock shouldn't last forever, especially considering that its growth is likely to accelerate in the future and help justify its expensive valuation.