Sometimes a stock comes along that really divides a lot of investors. Tesla is an example. Another is chip giant Nvidia (NASDAQ: NVDA). Some look at Nvidia stock and see a potential bargain, despite its $4.9trn market capitalisation. Others think it is wildly overvalued due to an AI-fuelled boom in demand for chips that will not last.
Personally I like Nvidia’s business model, but do have concerns about its valuation. Currently, the share price is 41 times earnings.
There are a couple of questions I ask myself whenever assessing whether it might be the time to add some Nvidia stock to my portfolio. Although I think about valuation of course, that is itself affected by those questions.
The one and only?
The first question is a fairly simple one: how big will the market for chips be? If it stays where it is, or even gets bigger as companies scale up their AI investment, fine.
My concern would be if it was to collapse because having spent billions on building AI infrastructure companies decide they are not getting sufficient return on capital. Such a scenario could happen. But I tend to think that, over the coming few years, the chip market will remain huge and indeed likely to expand not contract.
The second question is therefore the one that weighs most on my mind when it comes to Nvidia stock: what can the company do that its rivals cannot?
Why a moat matters
In other words, to borrow an expression from legendary investor Warren Buffett, what is Nvidia’s “moat”?
The company may only have come onto many investors’ radars in the past few years, but in fact it has been around for decades. It has also been a technological innovator for decades.
The upshot is that Nvidia has developed technology that no other company has and, thanks to patents, can protect it. That is a classic Buffett-style moat.
Customers are not flocking to Nvidia to buy its costly chips in droves out of kindness. The company’s record revenue of $68bn in its most recent quarter – 73% higher than in the same quarter one year before – was not a stroke of luck. Rather, Nvidia has what companies seeking to build out AI infrastructure at scale has – and they are willing to pay for it.
Such strength gives the company pricing power. It recorded net income of $43bn on that $68bn of revenues. That 63% gross profit margin is something most businesses could only dream of.
I’m sitting out, for now
If Nvidia’s technological lead holds, it may potentially keep growing revenues and earnings at a strong clip. That could support an even higher valuation for Nvidia stock.
But that might not happen. Rivals are investing heavily in research and development.
The tech development cycle often involves a dominant player either getting leapfrogged on technology, or dramatically undercut on price for a product that while not as good is deemed by many customers to be good enough, given the price differential.
The current Nvidia stock price does not offer me sufficient margin of safety to reflect that risk, I feel. So I will not be investing for now.
