Summary
My last two bearish articles about Nvidia Corporation stock did not age well because I underestimated the strength of the momentum caused by the AI frenzy.
Nvidia stock is overvalued even with wildly optimistic assumptions, and the current market cap is higher than the cumulative revenue over the next decade.
The significant risk for a bearish thesis is that nobody knows how long the AI mania may last before the bubble bursts.
BING-JHEN HONG/iStock Editorial via Getty Images
Investment thesis
This is my third analysis of Nvidia Corporation $NVIDIA Corp(NVDA)$; the previous two did not work well, to be honest. My last article about the stock went live just before the latest earnings call. I underestimated the artificial intelligence ("AI") hype, though I mentioned the risk of a short-term bull run after the earnings release in my last article. Note that the next NVDA earnings report is scheduled for Wednesday August 23rd post-market.
Yes, the company massively upgraded its guidance for the upcoming quarters, and the market's positive reaction was fair to some extent. But the current situation with Nvidia stock reminds me of the so-called "Greater Fool Theory," because the current valuation is far above the underlying fundamentals. I know that Nvidia bulls will destroy me in the comments section, but in this article, I want to warn more conservative investors because someone will definitely become the Greatest Fool at the end of the day when this AI-fueled frenzy will terminate. Nothing is infinite, and valuations matter the most in the long run. I reiterate my "Sell" rating because the stock is substantially overvalued even with very optimistic underlying assumptions.
Recent developments
On the 24th of May, the company announced its latest quarterly earnings, delivering above the consensus financial performance.
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The NVDA stock price surged more than 20% on the day after earnings were released, and the main driver for the growth was the updated guidance for the upcoming quarter. Q2 of FY 2024 revenue is expected by consensus estimates at $11.07 billion, meaning a staggering 65% YoY growth is expected for the upcoming quarter. This was a massive upgrade of revenue guidance and significantly affected the long-term consensus earnings estimates. Below you can see the difference.
Compiled by the author
I would like to emphasize that Nvidia's current $1.08 trillion market cap is higher than the cumulative revenue the company is expected to earn over the next decade. Here I would like to add some context: the largest public company in the U.S., Apple $Apple(AAPL)$, is expected by consensus to generate a total of $5.7 trillion in sales over the next decade, which is about two times higher than the current market cap of AAPL. Just an exciting observation.
Now let me return to Nvidia's past quarter's performance. Revenue delivered a 13.2% YoY decline, and the operating margin declined substantially.
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The past quarter's weakness was mainly due to a substantial decline in the Gaming end market with about a 40% decline. Professional Visualization [PV] market also demonstrated a dramatic drop, where sales more than halved. On the other hand, the increased penetration of AI caused solid growth in the Data Center market. Though, a 14% growth did not outweigh the weakness in Gaming and PV. On the other hand, Gaming demonstrated a solid 22% sequential revenue growth meaning that challenges for this market appear to be in the rear-view mirror.
During the earnings call, Nvidia's management also announced several new offerings to the market, which are more powerful and address the requirements of the rapidly evolving technological environment. Overall, I look very optimistic about the company's future performance and consider Nvidia to be one of the main beneficiaries in the AI economy. But expectations about Nvidia's future profits are very hot, and now let me move to valuation to assess whether the current stock price reflects the fair value of future cash flows.
Valuation update
Nvidia stock delivered a staggering 200% price increase year-to-date, significantly outpacing the broad market and all semiconductor competitors. The stock trades about 38% higher than its previous all-time highs of late 2021.
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Seeking Alpha Quant assigns NVDA stock the lowest possible "F" valuation rating. Look at these ridiculous valuation multiples: about 54 forward FCFs and 24 forward sales. Current valuation multiples look unrealistic even for an inherently overvalued stock like Nvidia. If you had trillions of dollars available in your bank account to buy full ownership of any company, would you pay fifty-four times next year's free cash flow to get 100% control of such a company?
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Now, let me update my valuation analysis because consensus estimates changed significantly since I wrote my last article. I will simulate different very optimistic scenarios to demonstrate that NVDA stock is overvalued even under ridiculously optimistic assumptions.
First, let me start with a revenue growth trajectory expected by consensus estimates. In this case, revenue CAGR is about 13% for the next decade. I use a ten percent WACC as I usually do for U.S.-based semiconductor companies. I use a very optimistic free cash flow ("FCF") margin dynamic, starting at 20% in the current FY and expanding by two percentage points yearly. If the company sustains this FCF margin expansion path, it will achieve a 38% FCF margin by FY 2032. Let me remind you that over the past decade, neither Apple (AAPL) nor Microsoft $Microsoft(MSFT)$ ever achieved even a 30% annual FCF margin. That said, my FCF margin estimations are massively optimistic. But even under these unrealistic profitability metrics, the stock is still about 37% overvalued.
Author's calculations
Special for Nvidia fans and bulls: I would like to go even further for a more optimistic scenario with a 9% WACC and 50% [not a typo] FCF margin for the termination value calculation. Even with these extremely favorable assumptions, my DCF model suggests the stock has about 13% downside potential.
Author's calculations
Finally, let me simulate a DCF with reasonable assumptions for investors unwilling to become the "Greatest Fool." I will use the exact consensus revenue growth estimates and a 10% WACC but will implement a 50 basis points yearly FCF margin expansion. Under these assumptions, the business's fair value is more than twice lower than the current market cap.
Author's calculations
Overall, various optimistic DCF valuation simulations together with multiples suggest that NVDA stock is massively overvalued, especially after the last three-months bull run.
Risks update
A single major risk for my bearish thesis is the robust Nvidia stock's momentum fueled by the AI craze.
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Please don't understand me wrong. I do admit that AI is a real breakthrough for humanity. AI is a game changer for individuals and businesses, and I am also an AI bull. But did we not know about AI and its advantages before this year? Actually, we did, and we used multiple AI features for several years. Therefore, the extent of this year's AI craze looks unreasonable to me.
History taught us that when an asset's price surges 200% within a relatively short period, the "Greater Fool Theory" part of such a bull run is significant. We have seen it a lot of times, especially during the "Dot-com bubble." And I consider this a short-term risk for my bearish thesis. You never know how big the bubble can ultimately become before it bursts. The timing of a burst is also very hard to predict. Therefore, there is a significant risk that the rally may last in the short term.
Bottom line
Overall, Nvidia Corporation stock is massively overvalued, even under wildly optimistic assumptions. We are highly likely in an "AI bubble," and the risk and the problem with bubbles is that it is hard to predict the timing of a burst. The AI frenzy might last for the next couple of months. But nothing is infinite and every day, the risk of a new NVDA investor becoming the "Greatest Fool" in this craze is increasing. The history of several other bubbles of the past taught us that any bubble will burst sooner or later. Therefore, I reiterate a "Sell" rating for the NVDA stock.
Source: Seeking Alpha
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