MW Here's what could slow Nvidia's momentum
By Mark Hulbert
Nvidia needs to grow by 70% a year to support its stock price
Nvidia's stock is unlikely to produce the return that exuberant investors are expecting.
Nvidia $(NVDA)$ shareholders need a reality check. Nvidia's stock price is currently trading on the implicit assumption of faster growth than even the most optimistic Wall Street analyst is projecting. Nvidia's stock is unlikely to produce the return that exuberant investors are expecting.
Pointing this out is not a criticism of the company, whose performance has been nothing short of phenomenal. It's a matter of simple math: How fast must Nvidia grow to support its stock price?
The answer depends on two key points:
What the stock's return will be over the next five years: It would be unrealistic to assume Nvidia's stock will appreciate at the same fantastic rate it has over the past 12 months (176%) or the past five years (100% annualized). Growth rates inevitably come down as companies grow. To be conservative, let's assume the stock grows at a 50% annualized rate over the next five years, even though many exuberant investors currently are extrapolating the triple-digit returns over the last several years.What Nvidia's P/E ratio will be in five years: The stock's P/E currently is 93, based on latest fiscal year earnings. Sky-high P/E ratios don't stay that way forever, so Nvidia's P/E almost certainly will be lower in mid-2029. Let's assume that the company's P/E in five years will be 50. That's also conservative, since the largest semiconductor companies have P/E ratios lower than 50, and the required EPS growth rate goes up as the assuming P/E ratio goes down.
Given these two assumptions, Nvidia's earnings per share must grow at a 70% annualized rate over the next five years. That's more than double the consensus expectation of Wall Street analysts, according to FactSet, which is a five-year annualized growth rate of 30%.
Historically, Wall Street analysts have been too optimistic on average. But even if we assume the consensus expectation of Nvidia's five-year earnings growth is right, holding everything else in my illustration constant, the stock's growth rate between now and mid-2029 will be 15.2% annualized. That's nothing to sneeze at, but much lower than what most Nvidia's investors are expecting.
Be my guest playing around with these numbers. You'll be hard-pressed to come up with reasonable assumptions that support the inflated expectations of Nvidia's more exuberant investors.
Qualcomm teaches a lesson
A helpful analogy is Qualcomm $(QCOM)$, one of the highest-flying companies of the dot-com era. Its stock rose 26-fold in 1999 alone. Upon focusing only on how much the company's earnings have grown since then, you might conclude that the high stock price at year-end 1999 was justified. Research Affiliates recently pointed out that, since 1999, "Qualcomm's business growth has been stupendous. In the following 23 years, its sales and profits per share grew by 14% and 19%, compounded per annum. Qualcomm's profits are now 60 times as large as they were at its peak in 2000."
Yet the performance of Qualcomm's stock since 1999 has been disappointing. The Research Affiliates study calculates its return from 1999 through the end of 2022 to be just 2.8% on an annualized basis - less than half the S&P 500's SPX return.
How could a stock with "stupendous" sales and profit growth lag the market by so much? The answer, according to the Research Affiliates study: "The good news was [already] fully reflected in share prices!"
The same appears to be true about Nvidia stock today. In order for it to live up to investors' exuberant expectations, the company's earnings will have to grow even faster than the good news that is already being discounted. That's a tall order.
Growth-rate reality
This skeptical conclusion applies even assuming that Nvidia's earnings per share will grow at the 30% annualized pace Wall Street expects. But most likely this assumption is itself overly optimistic. That's the implication of a landmark study, which found that, historically, it's very rare for companies' earnings to grow at a faster-than-median pace for more than a couple of years in a row. Beating the median is a far lower bar over which to jump than 30% annualized.
The study, published two decades ago, was entitled "The Level and Persistence of Growth Rates." It was conducted by Louis K. C. Chan of the University of Illinois at Urbana-Champaign and Jason Karceski and Josef Lakonishok of LSV Asset Management. The researchers analyzed all publicly traded U.S. stocks back to the 1950s, searching for those that had above-median sales growth for several years in a row. They found that the number of companies hurdling this low bar was no higher than what you'd expect on the assumption of pure chance. A subsequent study by Verdad Research, analyzing the two decades since the Chan/Lakonishok/Karceski was published, reached identical results.
The bottom line? The odds that Nvidia's earnings can continue growing at their recent pace appear to be no greater than those associated with flipping a coin. And even if Nvidia can beat those odds, as Wall Street analysts are expecting, the company's stock price still is unlikely to continue rising at its recent blistering pace.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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Also read: Big Tech's 'fake-it-till-you-make-it' hype is now infecting AI
-Mark Hulbert
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June 08, 2024 13:11 ET (17:11 GMT)
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