Is NVIDIA in a Bubble?

NVIDIA (NASDAQ:NVDA) has been the single biggest beneficiary of the AI boom of the last year and a half. Once viewed as just a maker of graphics chips for gaming, the company has become the default manufacturer of the advanced processors that support large language models (LLMs) for generative AI.

Thanks to the sheer degree of investor enthusiasm surrounding this technology, though, there is at least a chance that NVDA shares are trading in a bubble.

Has irrational hype on a new technology run amok, or is NVIDIA still trading based on its fundamentals?

The Case for an NVIDIA Bubble

On the surface, the case for NVIDIA being in a bubble is fairly compelling. The stock has advanced almost 3,600% over the last five years.

Even today as a company with a market capitalization of over $3.2 trillion, NVIDIA still looks to be priced as a rapid growth stock. NVDA shares trade at about 53x sales, 52x forward earnings and 106x cash flow.

Furthermore, NVIDIA’s share prices are almost entirely supported by expectations of further investment in AI technology.

Many economists now believe that a bubble has formed around AI stocks in general, sending US equities to extremely high prices based on irrational enthusiasm. Though it’s not a guarantee that the company is part of this bubble, its deep exposure to the AI market has the potential to cause a general AI bubble that envelopes NVIDIA.

NVIDIA’s pricing also basically demands that the company remain ahead of any potential competitive risks. The problem, though, is that the increasingly lucrative AI chip market is a magnet for competition.

Several tech titans, including both Meta and Alphabet, are beginning to make and sell their own proprietary chips. Though these companies are unlikely to unseat NVIDIA at the top of the AI chip market, such well-capitalized technology firms are likely to apply heightened competitive pressures that the company hasn’t historically had to face.

Taken together, these factors paint the picture of a stock with an extreme valuation, a potentially unrealistic view of the competitive environment and a high degree of investor hype behind it. Collectively, these factors indicate a bubble forming around NVIDIA.

The Bullish Case for NVIDIA

Despite some evidence that NVDA’s current pricing may be the result of a bubble, there are also some very strong arguments to the contrary.

To begin with, NVIDIA’s fast-rising share price has corresponded to real hikes in earnings. In Q1 of this year, for instance, NVIDIA earned $0.60 per share. In the same quarter of 2020, that number was just $0.04 per share.

With earnings having multiplied by 15 times over such a short period, it’s hard to argue that NVIDIA’s run-up has been purely the result of excessive market enthusiasm.

NVIDIA’s pricing also isn’t as untenable as it initially looks when future growth expectations are taken into account.

Despite a P/E ratio of over 50, the stock’s price-to-earnings-growth (PEG) ratio is a much more reasonable 1.4. Though still a bit high, this ratio suggests that NVIDIA isn’t massively overvalued as long as its earnings can keep growing at the expected pace.

So, though an AI bubble is possible, it’s hard to argue with the investment thesis behind NVIDIA as the driving force at the center of a market that could grow at a blistering pace for several years to come.

By 2030, the market for AI chips alone is expected to be worth over $300 billion. Even with competitive pressures, NVIDIA is in an excellent position to capture a large section of this market.

As far as competition goes, there’s no doubt that other companies will try to take market share from NVIDIA. However, the company has an enormous first-mover advantage in the form of its software platform, CUDA.

Because CUDA is used to support AI development with NVIDIA’s hardware, it’s the software environment that most AI-focused programmers are familiar with.

To breach NVIDIA’s moat, therefore, other chipmakers will have to not only create superior or cheaper chips but also create a similarly popular programming environment.

A final factor that may well suggest NVIDIA isn’t in a bubble is the fact that the company is rapidly moving to pass some of its earnings onto shareholders in the form of dividends.

NVIDIA announced a 150% increase to its quarterly dividend after its Q1 report. Though the dividend from NVDA shares is still very modest, this move suggests that management sees continued dividend payments at a much higher level as a sustainable way to return cash to investors.

This doesn’t inherently mean that NVIDIA can’t be in a bubble, but the decision implies a belief that earnings will continue to rise steadily and eventually justify the stock’s high valuation.

So, Is NVIDIA in a Bubble?

Based on its price-to-earnings ratio relative to earnings growth of 1.4x, NVIDIA stock is not in a bubble yet.

There is little denying that NVIDIA is an expensive stock with a valuation that may be pricing in a best-case growth scenario.

With that said, it’s hard to make the case that NVIDIA is truly in a bubble, as the stock’s growth corresponds to both massive improvements in earnings and a very real growth runway ahead for the company. So, while moderate overvaluation could still be on the table, NVIDIA doesn’t seem to fit the classic mold of a bubble.

Though NVIDIA itself may not be in a bubble, it’s worth considering the risk that the stock is at least bubble-adjacent.

Many stocks have surged on AI hype without posting the kind of exceptional earnings growth NVIDIA has managed. If the AI bubble does eventually burst, it’s quite likely that NVIDIA shares would suffer as investors temporarily soured on AI stocks. Provided the company’s fundamentals remain strong, though, it’s likely that the stock would gradually rebound.

Just because NVIDIA doesn’t look to be in a bubble, though, doesn’t mean that it’s a low-risk investment. The stock’s price will require multiple years of high earnings growth, and the company will have to remain out in front of the many competitors that will be looking to take market share from it.

Though NVIDIA certainly has the potential to justify the enthusiasm that has built up behind it, investors should clearly understand the risks that the stock could carry if it fails to meet the very high performance expectations the market has placed on it.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.