The suspense was riveting. Seldom if ever has an earnings report been more eagerly anticipated than Nvidia's release following the market close on August 23. The leading maker of data center gear used in A.I. systems delivered big-time, lifting its GAAP net profits an incredible $4.2 billion or 218% just during the three months ended July 30. That performance far exceeded analysts' already sumptuous forecasts, and CEO Jensen Huang lifted expectations for triumphs to come by pledging another 18% profit jump in Q3.
Those blowout numbers elicited heights of hyperbole on Wall Street. Analysts lauded Nvidia's "epic print [that's] simply unprecedented," its coup in "putting the bears back in hibernation," and its sudden rise to reign as "the most important company in civilization."
Nvidia stock has a momentous challenge from here
On August 24, Nvidia opened up over 6% from its close the previous day. By noon, the jump had faded. But the super-strong report still lifted its market cap by another roughly 2% or around $22 billion, to $1.19 trillion. That bump swells the total lift to its valuation since the start of 2023 to 70%, or $820 billion. Rather than viewing Nvidia's stock as highly inflated based on its current earnings and the frenzy over A.I., the analyst community generally predicts huge gains to come on top of a sudden surge seldom witnessed in the annals of capital markets. Following the release, 20 firms raised their estimates for its shares; the average target now stands at $600, 25% above its level of about $480 on midday on Aug. 24.
A reasonable projection on what Nvidia must accomplish to be worth the current $1.19 trillion, let alone the average of $1.5 trillion the Wall Street crowd's positing, suggests that its shares are anything but a good buy. More likely, they're substantially overpriced. David Trainer, chief of research firm New Constructs, developed a "reverse discounted cash flow" model to project how fast its margins and sales must grow over the next 25 years to justify its current valuation. The bogies are high indeed: hiking after-tax profit margins from 29.5%, based on the trailing four quarters, to 44%, and raising revenues at an annualized pace of 20%. "Nvidia's valuation is ridiculous," says Trainer. "People should not be chasing this stock before it drops by around 80% to below $100."
Nvidia's profits are unlikely to rise fast enough to justify its high stock price
I ran an analysis from a different angle than Trainer's: measuring how rapidly Nvidia's profits must wax to deliver investors 10%, compound yearly returns over the next seven years. Since it doesn't pay a dividend, and is unlikely to do so, all gains would flow from an increase in its share price. We'll make the optimistic call that Nvidia won't need to sell stock for funding growth, and will hold its share count constant. Hence, notching that 10% yearly gain by the summer of 2030 requires doubling the market cap to nearly $2.4 trillion.
That's one scary number. The only U.S. company past that threshold is Apple ($2.8 trillion). Nvidia would need to match the $2.4 trillion mark where Microsoft stands today.
We'll further project that in 2020, Nvidia will command a P/E ratio equal to the current Nasdaq 100 multiple of 23. Given those assumptions, Nvidia faces the challenge of growing its yearly net GAAP profits in the next seven years to $104 billion by the close of that period. (That's the projected $2.4 trilion valuation divided by a multiple of 23.)
Still, what excites Wall Street is the series of gigantic quarter-over-quarter leaps, and the expectation of many more to come. It's unfair to use Nvidia's 12 month trailing numbers as a starting point because it's expanding profits so fast. Instead, we'll annualize its spectacular Q2 earnings, and use that far-bigger number as our base. The big question: How fast must Nvidia climb from this summit that's already 19% higher than in Q2, and five-and-a-half times above Q2 of 2023?
Nividia's profits hit $6.2 billion in Q2. So on an annualized basis, its earning stand at $24.8 billion, putting its PE at a lofty 50. In our model, to reach the $104 billion mark by 2030 and furnish that 10% annual return, Nvidia must multiply that $24.8 billion run rate well over four fold, or by 22% a year.
Nvidia faces two headwinds caused by the "law of large numbers." First, it must clinch earnings bigger than any U.S. company generates today. At $104 billion, it would be garnering 9% more than the $95 billion that Apple, America's biggest earner, made in the past four quarters; exceed Microsoft's current $72 billion by 44%; and better the Alphabet record by 55%.
Second, the mandated profit growth rate of 22% is so off the charts that it appears unachievable. Case in point: In the four quarters spanning mid-2029 to mid-2030, the success scenario foresees a stupendous earnings hike of almost $20 billion.
Put simply, it's the rigors of competition that will most likely prevent Nvidia from reaching the pinnacle envisaged on Wall Street. "The rest of the world won't just roll over and let them dominate A.I.," says Trainer. "They're facing the same curse as Tesla. Nvidia benefited like Tesla from being first to market. But when Tesla got profitable, loads of competitors entered the EV space, cutting its margins and slowing sales. The same will happen for Nvidia." Nvidia is a great innovator and an outstanding operator. But by driving its price so high on hype and hope, investors have built a hill too steep for even this daring pioneer to climb.
