May 28th, 2023
By (Raffaele Domenico Rinaldi, Equity Research Analyst)
Edited by (Ascanio Cicogna, Head of Research)
The high volatility of NVIDIA stock.
Nvidia Corporation (NVDA) is a US technology company that has become increasingly well known in recent years. Its best-known product is certainly the "GeForce" series of GPUs, which is used as a video card in most of our computers.
The pandemic and the advent of cryptocurrencies greatly helped sales of "Graphics" section, but the boom didn't last too long. The resolution of console production and distribution problems has reduced the sales of gaming video cards, as well as the drop in the price of cryptocurrencies, which has made mining less profitable. In recent months, NVIDIA is back on on the news as ChatGPT is run on Microsoft’s Azure system infrastructure and is powered by Nvidia’s GPUs. All these rapid changes have caused a lot of volatility to the stock, which has achieved a +100% gain since the beginning of the year. In this article I discuss whether this increase is based on fundamentals or just a sign of excessive euphoria.
The problems that NVIDIA faced in 2022.
To understand whether NVIDIA is overvalued or not, we need to analyse how the company is going by looking at its balance sheet. NVIDIA consists of two divisions: the first and best known is "Graphics", while the second is "Compute and Networking".
As for the "Graphics" section, in 2022 there was a sharp drop in sales of more than 50%. Even the company itself did not expect this drop, in fact going to read the transcripts of the conferences with analysts, the company attributes this drop to the uncertainty caused by the war in Ukraine and by the lower prices of cryptocurrencies, which made mining less profitable. The following chart shows how NVIDIA's chart and Bitcoin's chart look very similar.
Furthermore, the drop in sales could also be interpreted as a return to the average, as sales during the pandemic period had grown a lot. During the pandemic, many gamers have decided to buy the 3000 series of video cards. In that period, in fact, gamers were unable to buy either a PS5 or an Xbox.
The rate hike also contributed to the 2022 stock market slide, as growth stocks (like NVIDIA) particularly suffer from this phenomenon, as they rely primarily on future cash flows that are now discounted at higher discount rates.
Figure 1: NVIDIA chart (blue) vs Bitcoin chart (orange)
Source: TradingView
Why is the stock rising in 2023?
Since the beginning of the year NVIDIA has risen by about 100% on the stock market, going from a valuation of about $140 to about $280. If you look at the low of October 2022 this figure becomes +150% even though the S&P500 has only grown by 15% in the same period. The stock's growth may have been driven by two factors: the growth of the "Compute and Networking" division and the advent of AI with ChatGPT.
The "Compute and Networking" division is quietly getting bigger than the "Graphics" division that everyone knows NVIDIA for. This division deals with chips and architectures for self-driving cars, robotics, video analysis software and in particular data centres for artificial intelligence and machine learning.
In the last period, machine learning, which is based on providing input to a computer and asking it to generate a solution explaining the procedure followed, is becoming more and more important. It requires very high computing power, therefore extremely powerful computers, and a software architecture capable of exploiting the powerful hardware are needed. Nvidia provides both hardware with NVIDIA DGX A100 and software with NVIDIA AI Enterprise.
Figure 2: The revenues of the two divisions compared.
Source: Yahoo Finance (Pietro Michelangeli’s chart)
It is the growth of “Compute and Networking” sector that has made NVIDIA's 2022 turnover decrease less heavily and, indeed, has captured the interest of investors. Most of NVIDIA's profits, in fact, derive from the "Compute and Networking" division as NVIDIA manages to have higher margins in this market segment.
In addition, ChatGPT is launched on November 30, 2022. All the attention was also on NVIDIA because ChatGPT is run on Microsoft’s Azure system infrastructure and is powered by Nvidia’s GPUs. Nvidia has received a lot of advertisement from this, and it is possible that any company that wants to create its own “new ChatGPT” could think of asking NVIDIA for help to do it.
Figure 3: The earnings of the two divisions compared.
Source: Yahoo Finance (Pietro Michelangeli’s chart)
Is the stock overvalued?
Using the DCF model we can try to understand what the current value of NVIDIA is. Of course, we need to make estimates about revenue growth, as well as discount rates. Even being extremely generous, however, the value of this share is very far from the price on the stock market. Current EPS is $1.75 and P/E is 160!
From the extremely simplified and optimistic model below, the current value would be approximately $177 per share. This valuation is based on EPS growth of 25% annually for the next 5 years and 20% annually for the next 5 years. The final P/E used to calculate the Terminal Value is 40, double what the P/E of the S&P500 is in normal situations. EPS would go from about $2.19 to a whopping $13.29 in 10 years. This suggests that the valuation made is purposefully very optimistic. Current prices, even in the best-case scenario, are approximately 36% higher than fair value (currently equivalent to $103).
Figure 4: The valuation of NVIDIA
Source: Yahoo Finance and my own analysis
Conclusion: Summary
NVIDIA is a company that will probably grow a lot in the coming years given its commitment to the production of video cards and products and services related to artificial intelligence. However, the stock appears to be trading above its fair value and this could be due to the euphoria of investors who have excessively positive sentiment. Obviously, it is not easy to understand if (and when) NVIDIA will return to its fair value. The idea of shorting the stock might seem interesting, even if in the short-term market movements are difficult to predict and this would make the operation risky. Furthermore, betting against such a strong positive trend is not easy.
However, the factors we have discussed in this article suggest that this stock is probably overvalued and therefore you should not add it to your portfolio at current prices.
Citations:
Waters, R. (2023) It’s all about the chips in the AI War, Financial Times. Available at: https://www.ft.com/content/0a16c45f-5739-43ad-abdc-1b91afa83e0d (Accessed: 27 May 2023).
Waters, R. (2023b) Nvidia extends its AI ambitions to the cloud, Financial Times. Available at: https://www.ft.com/content/e0ed74c3-c156-4b8c-b904-242298edb3a6 (Accessed: 27 May 2023).
Tremolada, L. (2023) Reti neurali, Ray Tracing E DLSS: Così nvidia cambia il gioco SU PC, Il Sole 24 ORE. Available at: https://www.ilsole24ore.com/art/reti-neurali-ray-tracing-e-dlss-cosi-nvidia-cambia-gioco-pc-AEXWHK8C (Accessed: 27 May 2023).
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