The world, outside just the investing community, was introduced to NVIDIA (NVDA) last week. Apple, Amazon, Google, and more recently Tesla, have been the sexy growth stocks everyone has known about for years. Now, though, this semiconductor giant has gone mainstream. With artificial intelligence (AI) casting arguably more fear than optimism on Main Street America, NVIDIA’s $184 billion single-session market cap climb last Thursday was remarkable but concerning all at once.

The Earnings Report Heard ‘Round the World

Digging into the numbers, the California-based tech company posted just about the most stunning quarter and outlook you will ever see. First-quarter earnings per share verified at $1.09, topping analysts’ estimates by $0.17. Revenue also beat – Q1 net sales were $7.19 billion, $670 million above Wall Street’s expectation. 

The showstopper was NVIDIA’s guidance. For the current quarter, its management team forecasts revenue of $11 billion compared to consensus that was just $7.11 billion. Amid a surge in AI interest, NVIDIA said it was significantly increasing the supply of products related to its data center segment. While data center growth was once seen as lackluster this year, 2023 revenue in that business area could be double that of 2022 all thanks to AI mania.

A Historic Market Cap Rise

Shares soared immediately after numbers hit the tape. Up more than $200 billion in market cap at one point on Thursday, the stock closed at all-time highs. NVDA with its $963 billion market cap is now the world’s 5th most valuable publicly traded stock.

But has the chipmaker come too far, too fast? That’s the question analysts and investors mulled over during the holiday weekend. We say yes. Our assertion is based on valuation and a realistic look at the future.

Consider that NVIDIA now sells for more than 37 times sales. Even when assuming forward estimates, the price-to-sales ratio of 22 is more than stretched – the sector median P/S is just 2.7 for perspective.

NVDA: Never Before Has It Traded at Such an Extreme Price-to-Sales Ratio

Source: Gurufocus.com

And you have to go back to the early 2000s to find a higher P/E multiple. Trading above 200 times last-12-month EPS is characteristic of what was seen in the late 90s among some of the dot-com bubble names.

> 200x Earnings

Source: Gurufocus.com

How to Think About Owning NVDA Today

That being said, this glamour stock is free cash flow positive and has impressive earnings. It even pays a small dividend. Hence, we had no qualms about owning it earlier this year through our contrarian Nasdaq 100 overweight position we’ve detailed over recent months. 

Investors must constantly look at their positions and prospective stock buys with fresh eyes, however. A good question to ask yourself after a rally like this is, “If I didn’t own the stock today, would I buy it now?” The exercise helps level-set your psychological view of what you own and don’t own. 

For us, we view buying NVDA with its nearly $1 trillion equity valuation as a losing proposition. Frankly, the valuation seems insane to us unless it can manage to grow revenue at a 30% CAGR over the next 10 years. That is highly unlikely. 

Beware the Institutional Pump and Dump

Now that AI hype is in full swing, we fear that NVDA is yet another example of institutional investors pumping up a stock to astronomical levels only to unload it to retail investors. This is a classic instance of understanding the difference between a good company and a worthwhile investment. 

Sure, NVIDIA is like the lone seller of picks and shovels during the 1849 gold rush, so its moat is currently wide, and margins are impressive, but, by now, everyone recognizes that. We do not believe in 100% efficient markets, but we see the writing on the wall when so much hope is baked into a stock price. Now’s not the time to overweight NVDA. Positions should be trimmed, and some profits harvested at the very least.

The Long-Term Challenge of Tech-Related Commodities

Something else to think about – the semiconductor chip market is like any other technology. Over time, it becomes commoditized, and margins begin to compress. While there is no doubt that NVIDIA will be incredibly profitable in the quarters and even years to come, new entrants will surely figure out a way to capitalize on the AI theme. The chip market pie will of course grow, but Economics 101 says that economic rent can only endure so long.

A dominant growth company in a hot market, such as NVIDIA in the semiconductor space, usually faces favorable conditions. High demand for its products, limited legitimate competition, and a unique market position all lead to high economic rent. Keeping that competitive edge is a tough task. While diminishing players like Intel fade, versatile up-and-comers may slowly gain a foothold and swipe away economic rent from a behemoth like NVIDIA. Will that happen overnight? No way, but growing competition in the chip space is something for investors with a multi-year time horizon to contemplate. CEO Jensen Huang even said as much on the Q1 conference call:

“We have competition from every direction - start-ups, well-funded and innovative start-ups, countless of them all over the world. We have competition from existing semiconductor companies...And so, we're mindful of competition all the time.”

An Imminent Crash? Maybe Not, But Capped Upside.

The probable outcome here is that NVIDIA simply grows into its valuation over the long term. We don’t expect the stock to crash any time soon, but with shares up about 170% year to date and annualizing at a whopping +60% clip over the last decade, it’s not like NVIDIA is an under-the-radar name anymore. An appropriate comparison is what happened with Tesla (TSLA) over recent years. It, too, captured the fancy of Wall Street and Main Street alike. 

Parallels to Tesla in 2021

TSLA and NVDA were in similar positions heading into 2020. Both companies were not yet grouped with the so-called FAANG stocks since their market caps were under $200 billion. Tesla soon took off, reaching a total equity value of more than $1.2 trillion. Institutions bid up Elon Musk’s darling by late 2021 as the retail crowd got involved. Individuals caught up in the hype were soon sorry; TSLA plummeted 70% by the end of 2022. 

Now here we are with NVDA. Like TSLA once hurdled, the high-flying chip stock is about to gain entrance into the trillion-dollar club. It probably makes it there and maybe even climbs higher as Tesla did. But history shows that such extreme bull runs often include massive drawdowns. We saw it with Apple, Amazon, and so many others over the decades. Thus, a bit of prudence likely pays off with NVDA. Waiting for those major corrections is tough to stomach, but it’s so much better than buying because of FOMO, then being left holding the bag when institutions begin selling to retail en masse.

The Bottom Line

Last week’s semiconductor price action had all the hallmarks of panic buying. NVIDIA’s blowout earnings report was no doubt impressive. The stock notched record-high volume on Thursday, topping more than 150 million shares. We urge caution, though. 

While Allio has liked the tech trade for a while now, we see trouble brewing. Buying NVDA today, in our view, features more risk and reward potential due to the level of speculative fervor and the reality that large investors may soon dump their shares to the retail crowd.