By Daniel McGarvey, Portfolio Analyst
On May 30th, Nvidia became the sixth U.S. company and first-ever chipmaker to reach a $1 trillion market capitalization. The 30-year-old company’s massive price surge came after a blowout earnings report that included revenue projections over 50% higher than analysts expected, largely due to artificial intelligence (AI) prospects. The optimism about the effects of AI spilled over into some other high-tech stocks as well, with giants such as Google and Microsoft racing to capitalize on what appears to be the next gold rush of the technology industry.
The inevitable question this raises is whether AI will actually generate the cash flows priced into current valuations and which companies will benefit the most. In the case of Nvidia, the growth necessary to justify its price-to-earnings (PE) ratio of 197 is quite high. The forward PE is lower at 49, but even if its PE came down to a ratio of 20 in 10 years, these prices would require an average annual earnings growth rate of almost 27% over that time. Its price-to-sales ratio compared to its main competitors also sets a high bar for the market dominance it will need to achieve (see chart below).
As far as which companies will survive the AI wave, the future is uncertain, but it appears that Nvidia is priced to be the only company selling shovels for the gold rush. It does produce around 80% of the market’s graphics processing units (GPUs), which power generative AI, making it today’s unquestionable leader. However, the market seems to expect that its leadership will stay unquestioned indefinitely. The market could very well be right, but we would be hesitant to overweight the stock at these prices since its industry can evolve so rapidly.
An additional factor to consider is the potential for regulatory risk as scientists, politicians and executives sound the alarm on AI’s potential harm to humanity. Experts have called for pauses in development so that the industry can set safety standards, and any ethical concerns could create significant headline risk. While AI could certainly transform the world as we know it, we would caution investors that the landscape is difficult to predict, and the major players are already priced for substantial growth.
May was a mildly positive month for stocks as the S&P 500 returned 0.5%, although the top of the market drove returns. The Bloomberg US Aggregate fell 1.1% as the 10-Year Treasury rate rose to 3.6%, and high yield spreads remained around 4.6%. As of the end of May, the market is pricing in one more rate hike in July, with only a 34% chance of rates dropping below their current levels in 2023. It also appears that the debt ceiling saga is winding down, and we expect that ceiling will be raised by the time this commentary is published. The proposed deal will suspend the ceiling through January 2025 and aims to reduce government deficits by about $1.5 trillion over the next decade.
Charts provided by YCharts, Inc.
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Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.