A price-to-earnings (P/E) ratio of nearly 74 would generally be considered a stunning valuation for any stock. To put that multiple into perspective, it’s nearly three times the P/E ratio of S&P 500.
Nvidia (NASDAQ:NVDA) Nvidia’s stock price is currently almost 74 times trailing 12-month earnings. Unsurprisingly, many investors believe the chip’s stock price is high. But could they be wrong? Is Nvidia stock really undervalued?
In the eyes of the spectator
Let’s start by defining the term “undervalued.” Oxford Languages, the world’s largest dictionary publisher, defines it as “something that is not sufficiently valued or appreciated” or “has an underestimated financial value.”
I would say that any rational investor who owns Nvidia shares believes that the stock is undervalued based on this definition. Why? It would make no sense to hold the stock if he did not believe that it was already sufficiently valued and appreciated or that it had a higher financial value than it should be.
Of course, not everyone will agree with these investors. Yet that’s how the stock market works. Buyers of a stock believe that a stock has more room to run (i.e., it is not valued enough). This is generally not the case with sellers. Enhancement, like beauty, is in the eye of the beholder.
Of the 36 analysts surveyed by LSEG in June, 21 rated Nvidia a Buy or Strong Buy. Many on Wall Street seem to view the stock as undervalued. How can they have such an optimistic opinion in light of Nvidia’s sky-high P/E ratio? It’s simple: they believe the company’s growth more than justifies its current price.
How much growth does Nvidia need to grow?
This begs the question: how much growth does Nvidia need to generate to be undervalued today? There are several ways to answer this question.
A quick and dirty approach is to use the Price/Earnings/Growth (PEG) ratio. This ratio is calculated by dividing the P/E ratio by the expected annual growth rate of earnings per share (EPS), usually the projected growth over the next five years. Any PEG ratio below 1 is considered an attractive valuation.
The math is simple using the PEG ratio. With Nvidia’s P/E ratio near 74, the company would need to generate annual EPS growth of around 74% over the next five years to be undervalued today. Some investors might believe that such a high growth rate is entirely possible. After all, Nvidia’s EPS climbed 629% year over year in the first quarter of 2024. Its growth could slow significantly and remain above 74%.
Another more complex approach consists of carrying out a discounted cash flow analysis. This method helps investors determine the current value of a stock using expected future cash flows. Aswath Damodaran, a finance professor at NYU known as the “Dean of Valuation,” built a discounted cash flow model showing that Nvidia’s revenue could grow at a compound annual growth rate of 32.2% while being overvalued by more than 80%.
A hesitant response
Will Nvidia generate enough revenue and earnings growth over the next five years that the stock is truly undervalued right now? Maybe, but several things could get in the way. The current rush to develop generative AI applications may be slowing down. Competitors could introduce new chips that would eat into Nvidia’s market share.
Wall Street expects Nvidia’s profits to grow about 43.2% annually over the next five years, according to LSEG. That’s a staggering growth rate, but it won’t be enough to bring Nvidia’s PEG ratio below 1.
I don’t think Nvidia stock is undervalued using conventional valuation models. However, that doesn’t mean its momentum won’t continue. All it takes is enough investors think Nvidia stock has room to run and continues to buy it hand in hand. As I said earlier, evaluation is in the eye of the beholder. Many investors view Nvidia as undervalued and may continue to do so.
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Keith Speights has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.
Is Nvidia stock really undervalued? was originally published by The Motley Fool
