Probably the most anticipated earnings report during this quarter is from Nvidia (NVDA -0.18%). After all, the chip maker's incredible guidance for its fiscal 2024's second quarter, ended July 30, sparked the artificial intelligence (AI) stock market rally at the end of May.
With Nvidia's stock up 43% since it reported earnings and 200% this year, investors may wonder what they should be doing with their shares. I think there are some red flags investors should be paying attention to, and investors should read on to find out what they should do with the stock.
A disappointment ahead?
In its Q1 earnings report, Nvidia issued guidance for its second quarter of $11 billion in sales, indicating 64% growth. Not only would that be an incredible rise, but it would also eclipse Nvidia's highest quarterly revenue mark by a significant margin.
NVDA Revenue (Quarterly) data by YCharts
But the question is, can Nvidia do it? Management likely saw some business trends indicating that this growth would occur, but if you look at peer AMD (AMD -1.03%), it doesn't seem likely.
Although AMD and Nvidia's quarterly calendar is shifted by one month, it's the best proxy available for Nvidia, even though the business makeup is different too. AMD's data center division fell 11% in Q2, which doesn't bode well for Nvidia's bold projection. Additionally, AMD's gaming revenue fell 4%, showing another critical market Nvidia hasn't recovered from yet.
While AMD and Nvidia's businesses are quite different, demand for their products is highly influenced by macroeconomic trends. As a result, their businesses display similar growth and decline patterns.
NVDA Revenue (Quarterly YoY Growth) data by YCharts
So with AMD's revenue falling 18% year over year in Q2, it's hard to imagine a scenario where Nvidia's revenue is up 64%. In my opinion, Nvidia is likely to fall short of expectations in Q2. Regardless, its stock is priced for perfection, and any deviation from its 64% growth guidance to the downside would spell disaster for the stock.
Nvidia is priced for perfection
Nvidia holds the title of one of the most expensive stocks on the market, trading at 42 times sales. Most stocks are considered expensive when they trade at 42 times earnings, let alone sales. This indicates sky-high expectations for the stock as the company must rapidly grow to justify its price tag.
NVDA PS Ratio data by YCharts
For Nvidia to reach a more reasonable 40 times earnings valuation, it would need to improve its profitability and grow rapidly -- approximately a 50% compound annual growth rate for three years and regain a 30% profit margin (near its peak profitability) while the stock price stays flat. That's likely an unrealistic expectation as it would involve Nvidia growing its revenue from $25.9 billion to $87.4 billion. For reference, hardware store Lowe's has trailing-12-month revenue of $95.8 billion.
That would mark a significant jump in revenue for Nvidia, and the market likely can't support its revenue essentially tripling. As a result, I think expectations are mismatched with the market opportunity. While Nvidia will likely see remarkable business gains over the next few years, I think the market has overhyped this stock. I think investors are best off to take some gains off the table.
However, holding on to a small portion of Nvidia shares in case it beats expectations may not be a bad idea as it may deliver incredible performance. The chances of that are low, in my opinion, and investors should use the market's gains in 2023 to take some profits.
Regardless, Nvidia's Q2 earnings report on Aug. 23 will be a must-read for investors as it has the potential to drastically shift the market in one way or another.
