This week saw Nvidia (NASDAQ: NVDA) break its own record, yet again. Nvidia stock hit a new all-time high, meaning it now stands 1,299% higher than it did five years ago.
Looking at that sort of rise, combined with a price-to-earnings (P/E) ratio of 55, it may seem easy to presume that the stock must be overvalued.
In practice, though, it can be impossible to tell that based on a share’s track record and current P/E ratio. Rather, I think valuation involves looking at what a business’s future prospects look like and then comparing that to its current price.
Nvidia is in uncharted territory
That can be difficult to do when it comes to Nvidia.
After all, the past few years have seen Nvidia stock soar in part because its sales revenues and profits have exploded. Not only is the share price in a place it has never been before, so is Nvidia’s business.
If that was a one-off phenomenon, as large companies raced to install AI-related IT infrastructure, then the current Nvidia stock price could be too high to justify in the long term. That might mean it is headed for a fall.
But if the past several years of AI demand are just the start of things to come, that could be good news for Nvidia.
Its revenues and earnings may grow even further. Lately it has managed to grow earnings ahead of revenues and economies of scale could mean that continues.
If that scenario plays out, five or 10 years from now, we might look back on today’s Nvidia stock price and think of it as a deep bargain!
Dealing with the unknown
To some extent, this sort of ambiguity is to be expected. After all, investing in the stock market always involves taking a view on how businesses will perform in future. In reality, that is never knowable for sure even at the staidest-looking firm.
But with Nvidia, there are a lot of moving parts.
On one hand, I see a lot to like.
Nvidia’s capital-light business model and proprietary chip designs mean that it has been able to achieve high profit margins. I see that as something that may well continue.
On top of that, it already has a large installed user base. That could be a competitive advantage if AI sales continue to boom, thanks not only to repeat purchases but also the power of that installed base in helping persuade new customers to choose Nvidia chips.
What might happen now?
On the other hand, though, we simply do not know how sustainable current demand for Nvidia chips is, let alone whether there is substantial room for ongoing growth at anything like recent levels.
The company faces regulatory pressure in key markets like the US and China. Smaller rivals are racing to try and produce cheaper chips that could offer some of what Nvidia does, threatening both sales revenues and profit margins at the industry leader.
At the right price, I could live with that risk. But given how highly Nvidia stock is currently valued, I do not feel there is a sufficient margin of safety. So, although I think it may still have further to climb, at the current level I am not willing to invest.
This story originally appeared on Motley Fool
