You’d be hard-pressed to find a hotter stock than Nvidia right now.
From the start of 2023 through June 8, the stock has returned more than 163% — a meteoric rise that has the chipmaker flirting with a $1 trillion market capitalization.
Currently, only four firms can say that the total value of their outstanding shares eclipses $1 trillion: Apple, Microsoft, Google parent company Alphabet and Amazon.com.
Nvidia differs from these firms in one key way: valuation.
Valuation is a blanket term that generally refers to the ways in which the market assesses a company’s worth. This is generally measured by comparing a firm’s share price with one of its underlying financial metrics such as earnings, revenue or cash flow.
When you buy a stock, you’re buying a share of a going concern that you expect to grow into the future, and stock prices typically reflect this potential growth. In essence, investors are willing to pay more for a company than what it’s worth today.
One way to measure this phenomenon is examining the company’s stock price compared to a fundamental measure, such as earnings or sales. If a company realizes $1 in earnings per share and trades for $10 a share, it’s said to have a price-to-earnings multiple of 10.
How a particular stock’s multiple compares to its own history (has it had this high a multiple before?), to peer companies (do tech companies tend to have high multiples?) and to the stock market at large (how does this firm compare to the average S&P 500 company?) determines whether investors consider a stock over- or undervalued.
Warren Buffett looks for stocks that trade cheaply compared with their underlying value — a strategy known as value investing. Other investors are willing to pay a large premium for a company they expect to deliver explosive growth.
Now, let’s get back to Nvidia and the trillionaires.
Nvidia’s stock currently trades for 204 times the company’s earnings per share. That’s lower than Amazon’s multiple of 296, but Amazon has always been an outlier in this regard; the retail giant rakes in boatloads of cash that it could convert to earnings if it wanted to. Microsoft trades for 35 times earnings, Apple for 31 times, Alphabet for 27.
Compare stock prices to sales and the difference grows starker. Amazon trades at 2.4 times sales, pretty much in line with the average S&P 500 company. Alphabet’s price-to-sales ratio is 5.6, Apple’s is 7.5 and Microsoft’s is 11.7.
Nvidia’s: 37.8.
What Nvidia’s high valuation means for investors
Based on earnings and sales, Nvidia comes with a higher price tag than the four biggest stocks on the market.
That doesn’t mean you shouldn’t buy it, or that you should sell it if you already own it. Rather, any prospective investor in Nvidia should do two things, investing experts say.
1. Examine the hype
Nvidia is not a meme stock. Investors are piling in because they believe in the fundamentals of the chipmaker’s business.
Namely, they think Nvidia has a chance to be the largest beneficiary of a technological revolution: artificial intelligence.
Nvidia is the dominant player in graphics processing units — an essential component for running AI in the cloud. Tech investors have seen this as a compelling opportunity for years, and Nvidia got a boost when OpenAI released viral chatbot ChatGPT earlier this year.
“It was an iPhone moment,” says Angelo Zino, senior industry analyst at CFRA. It forced companies across a wide range of industries to rethink how and how much they’ll be investing in AI.
“That makes it really hard to look at those conventional valuation metrics when assessing the magnitude of this opportunity,” adds J.R. Gondeck, managing director with the Lerner Group at Hightower Advisors.
Basically, investors are paying big now in the belief that the company’s fundamentals will eventually justify the price tag, and even make it look cheap in hindsight.
“Given the growth opportunities we see ahead, we think the multiple is fairly reasonable,” says Zino.
2. Prepare for volatility
If you believe in the long-term potential of a hyper-growth stock like Nvidia, you have to be willing to stomach some big drops in the value of your investment to reap the benefits, say investing pros.
During broad market selloffs, companies trading at the highest multiples often get hit the hardest. When investors are betting huge on a company’s future, and that future suddenly looks bleaker, things can get scary in a hurry.
“No tree grows to the sky,” says Gondeck. “You look at Apple, which recently hit an all-time high, and there were plenty of entry points along the way.”
Of course, they’re only “entry points” — or, buying opportunities — with the benefit of hindsight. If you’ve held Apple stock for decades, you’ve likely made a pretty penny. You’ve also experienced two drawdowns of more than 80%, between 1991 and 1997 and between 2000 and 2003.
“If you’re a long-term investor in Nvidia, there’s going to be a lot of volatility along the way,” says Zino.
To keep these sort of downdrafts from derailing your portfolio returns, build a core portfolio of broadly diversified exchange-traded funds and mutual funds, financial pros say.
And keep your individual stock bets to a relatively small corner of your portfolio. If you pick right, it’s a cherry on top of your portfolio’s performance. If not, you’re still theoretically on track to meet your financial goals.
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Check out: Nvidia is worth nearly $1 trillion—here’s how much you’d have if you invested a decade ago
