Valuation, like beauty, is in the eyes of the beholder.
A price-to-earnings (P/E) ratio of nearly 74 will usually be considered a nosebleed valuation for any stock. To put that multiple into perspective, it’s nearly three times the P/E ratio for the S&P 500.
Nvidia (NVDA -0.36%) currently trades at nearly 74 times trailing-12-month earnings. Unsurprisingly, many investors think the chip stock is priced at a steep premium. But could they be wrong? Is Nvidia stock actually undervalued?
In the eyes of the beholder
Let’s first define the term “undervalued.” Oxford Languages, the world’s top dictionary publisher, defines it as “not valued or appreciated highly enough” or “having an underestimated financial value.”
I’d argue that any rational investor who owns Nvidia shares thinks the stock is undervalued based on that definition. Why? It wouldn’t make any sense to hold onto the stock if they didn’t think it was already valued and appreciated enough or had a financial value that was higher than it should be.
Of course, not everyone will agree with these investors. However, that’s how the stock market works. Buyers of a stock think a stock has more room to run (i.e., it’s not valued highly enough). Sellers usually don’t. Valuation, like beauty, is in the eyes of the beholder.
Of the 36 analysts surveyed by LSEG in June, 21 rated Nvidia as a buy or a strong buy. Many on Wall Street seem to view the stock as undervalued. How can they hold such an optimistic opinion in light of Nvidia’s sky-high P/E ratio? That’s easy: They think the company’s growth more than justifies its current price tag.
How much growth does Nvidia need to deliver?
That raises the next question: How much growth does Nvidia need to deliver to be undervalued now? There are several ways to determine an answer.
One quick-and-dirty approach is to use the price-to-earnings-to-growth (PEG) ratio. This ratio is calculated by dividing the P/E ratio by the expected annual-earnings per share (EPS) growth rate — typically the projected growth over the next five years. Any PEG ratio of below 1 is considered an attractive valuation.
The math is simple using the PEG ratio. Since Nvidia’s P/E ratio is nearly 74, the company would need to generate annual EPS growth of roughly 74% over the next five years to be undervalued today. Some investors could believe this lofty growth rate is quite possible. After all, Nvidia’s EPS skyrocketed 629% year over year in the first quarter of 2024. Its growth could slow dramatically and still be above 74%.
Another more involved approach is to perform a discounted cash flow analysis. This method helps investors determine the present value of a stock using expected future cash flows. Aswath Damodaran, the NYU finance professor known as the “Dean of Valuation,” built a discounted cash flow model showing Nvidia’s revenue could increase at a compounded annual growth rate of 32.2% and still be more than 80% overvalued.
A wishy-washy answer
Will Nvidia deliver enough revenue and earnings growth over the next five years for the stock to be truly undervalued right now? Maybe, but several things could get in the way. The current rush to develop generative AI apps could slow. Rivals could introduce new chips that eat into Nvidia’s market share.
Wall Street projects Nvidia’s earnings will grow by around 43.2% annually over the next five years, according to LSEG. That’s an astounding growth rate, but it isn’t enough to bring Nvidia’s PEG ratio below 1.
I don’t believe Nvidia stock is undervalued using conventional valuation models. However, that doesn’t mean its momentum won’t continue. All that’s required is that enough investors think Nvidia stock has room to run and keep buying it hand over fist. As I stated earlier, valuation is in the eyes of the beholder. Many investors behold Nvidia as undervalued and could continue to do so.
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.
