Few stocks can compare with Nvidia's (NVDA 2.63%) incredible 190% rise this year. However, the stock has experienced some weakness over the past month and is down about 15% from its all-time high. With how impressive the stock has been, some might see this as a buying opportunity. However, the stock also has extremely high expectations built into it, so this could be a well-deserved cooling-off period.
So, is this a buying opportunity or the start of a larger downward movement? Let's find out.
GPUs have become the picks and shovels of the AI world
Nvidia's astounding run in 2023 is mostly coupled with the rise of artificial intelligence (AI). The company's primary products are GPUs, or graphics processing units. This hardware is utilized in systems where heavy computations are required, whether that is gaming graphics, engineering simulations, or processing data for an AI model.
While a single GPU may be useful for running basic calculations for a game, anyone in the AI field needs hundreds or thousands of these GPUs connected to have enough computing power to perform the arduous task of training an AI model.
As many businesses got excited about the potential use cases of AI assistants powered by large language models (LLMs), they began to explore building their own data centers to power internal models or inquired about increasing their usage of cloud computing systems. This directly translated to an Nvidia business boom, and the results have been incredible.
In the second quarter of Nvidia's FY 2024 (ending July 30, 2023), revenue rose an astounding 101% to $13.5 billion. Its data center division, encompassing the GPUs utilized for AI purposes, saw record revenue of $10.3 billion, up 171% from last year's Q2. But that's only the beginning. For Q3, Nvidia expects revenue of $16 billion, indicating 170% growth. It's rare to see revenue nearly triple in one year, but even more rare to see a company of Nvidia's size do it.
As a result of Nvidia's incredible performance and strong guidance, many investors piled into the stock in hopes of continued performance. But are they expecting too much?
Analysts believe Nvidia has a great year ahead
When a company grows as rapidly as Nvidia, it's hard to assess its future accurately. Right now, the stock has an incredible premium on it, regardless of the valuation metric used.
NVDA PE Ratio data by YCharts. PE Ratio = price-to-earnings ratio. PS Ratio = price-to-sales ratio.
When a company has a massive business change on the horizon, trailing earnings and sales aren't the best metrics to use, as they only consider the past, when we know the future will be different. So, we also need to look at forward earnings and sales, which factor in analyst projections over the next 12 months. This will also allow us to see what future expectations are baked into the stock price.
NVDA PE Ratio (Forward) data by YCharts. PE Ratio = price-to-earnings ratio. PS Ratio = price-to-sales ratio.
From these projections, analysts expect earnings to grow by 162% and sales by 70% over the next 12 months. If it can achieve these results without the stock price increasing, the stock will be valued at the current forward ratios after Nvidia reports Q2 FY 2025 results.
Clearly, that's some high expectations over the next year. But another question is, can Nvidia sustain it? After companies build or rent out their required infrastructure to create their models, will customers need to continue building data centers, or will they be content with their initial resources? This is a major unknown and can have serious consequences for the stock. If Nvidia has booming sales for one or two years and then loses them, the bottom will fall out of the stock.
This is a major unknown, so I have avoided Nvidia stock. While the 15% pullback is a nice opportunity for investors, I think the unknowns are too great to invest in it. However, if you believe this is a fundamental shift in how businesses operate and that we will need to build an indefinite amount of data centers to feed the demand, maybe this pullback is a buying opportunity. If you take this route, I'd exercise caution and take a relatively small position in your portfolio (say 1%); that way, it doesn't crush your portfolio if it doesn't work out.
Risk should play a part in position sizing, and Nvidia's risk is incredibly high.