3P-Check: NVIDIA

Is it possible, plausible or probable

What is the 3P-Check?

One of the goals I set for myself with Valuing Dutchman is to be a voice of rationality in the stock market. Advocating for calmness both in times of panic and euphoria.

The 3P-Check, intended as a recurring set of articles, is highly suitable for this purpose. The 3P refers to the terms Possible, Plausible, and Probable from Professor Aswath Damodaran's book Narrative and Numbers, also known as the Dean of Valuation. The goal of the book is to learn to link numbers to stories and vice versa.

We will examine the valuation of a company in the market and ask ourselves:

Is it Possible? Does the story that the current market price tells even have a chance of being true? Can a company grow so strongly, and increase margins,... You would be surprised how many impossible stories there are.

Is it Plausible? It is technically possible, but is it also plausible? Are the expectations realistic, are there precedents that support these stories and expectations?

Is it Probable? Is it likely that the stories associated with the current stock price will also unfold? The distinction between this step and the previous one is strongly based on the analyst's convictions. At this point, I will often disagree with others.

My goal with these articles is to pause and reflect on valuations, and based solely on numbers, determine in which of the three P's a valuation falls, according to my opinions. I will also do a quick calculation of what I would be willing to pay for the company in question.

Please note, that this latter part is not an in-depth analysis or valuation of the company. It's a simple calculation to determine at what price my interest would be piqued enough to start such an analysis.

Today, we cannot overlook the following company:

NVIDIA

At the time of writing, NVIDIA is currently the largest company in the world by market capitalization. It trades with a price-to-sales ratio of 41.51 and a price-to-earnings ratio of 79.19. The question is whether this valuation is justified by its growth.

Over the last ten years, NVIDIA has experienced revenue growth of 34%, and over the last three years, it's been as high as 60.6%. These figures are impressive. However, we must question whether the doubling between fiscal year 2023 and 2024 represents a new normal or is based on hype surrounding AI.

Looking at the nine years before this doubling, the average annual revenue growth was still a strong 21.5%, with accelerated growth particularly evident from 2017 onwards.

Profit has grown at an average annual rate of 55.1% over the past decade, and even faster at 100.6% over the last three years. Excluding the last year, growth remains at 22%, which is still impressive, but a lot lower. The past year was exceptional.

The significant profit growth in recent years is due to substantial margin improvements. Gross margin increased from 55.5% to 75.3%, operating margin from 16.2% to 59.8%, and net margin from 13.5% to 53.4%.

What we can say with certainty is that the growth of the past three years is not sustainable. If NVIDIA were to continue growing at this pace, its revenue would eventually surpass that of its customers. This is clearly not feasible, considering the costs customers incur for personnel, buildings, goods, taxes, etc. They cannot spend their entire revenue on NVIDIA. A valuation based on this assumption would fail the first P - this is not possible.

But that is also not what the current price on the stock market is suggesting, some price targets however,... 

What is the market expecting?

If an investor is satisfied with a return equivalent to the yield on a ten-year U.S. government bond, which is currently 4.48%, then the expected growth for NVIDIA over the next ten years would need to be only 12.5%, assuming current profit margins can be maintained.

If the investor seeks a 10% return, then NVIDIA would need growth of 32%. For a 15% return, growth would need to be as high as 43%.

These figures are derived from a reverse discounted cash flow valuation. I base these on the numbers from the last fiscal year. In the first quarter of the new fiscal year, NVIDIA crushed the year-over-year results but grew quarter-over-quarter by "only" 23%.

Achieving growth rates of 43% or 32% over a decade, while technically possible, seems unlikely given that quarterly growth has already fallen to 23%, even amid the AI hype.

In other words, the NVIDIA investors today demand a return, at the current stock price, that’s significantly lower than 10%.

Two big questions

The two questions we need to ask ourselves are: what growth seems achievable and are the margins sustainable?

Suppose NVIDIA manages to achieve growth of 22% over the next ten years from its current level. The return from the current price would then be 6.5%, assuming the margins remain intact.

A growth rate of 22% following the explosive revenue and profit increases of the past 18 months would already be quite exceptional, but it still falls under Plausible, it's possible. Whether one should be satisfied with a 6.5% return is another question.

Are the margins sustainable? NVIDIA's own average free cash flow margin stands at 19.25%, even including the strong years since 2017, not the current 32.6%.

Comparatively, competitors' margins are significantly lower, even in peak years for Intel and AMD, their margins did not rise as high. Assuming a 20% free cash flow margin for good periods seems optimistic over the long term. In downturns, this margin will likely more than halve.

Maintaining margins of 30% or more for more than a year or two seems unrealistic to me, given the strong competition. It's worth noting that NVIDIA's customers such as Microsoft, Alphabet, and Amazon, with their deep pockets, can also design their own chips if margins remain excessive. In this sector, you can lead for a few years, but not a decade.

What would I want to pay?

My starting point is that NVIDIA's revenue has not yet peaked today, but that annual growth over the next ten years will average around 20%, which for me translates to another one or two years of exceptional growth followed by a slowdown.

I calculate the free cash flow margin at 20%, a figure we've seen historically at both NVIDIA and its competitors, albeit on the higher side. This is an average assuming high margins in the early years due to their technological edge, followed by a decline as competition catches up.

To account for all these risks, I require a 12% return, which becomes my discount rate.

This would mean that today, I would be willing to pay $22.88 per share for NVIDIA, while the market price is $135.

This seems very low at only 13.2 times current earnings, especially considering the growth I also anticipate. However, this is all tied to my expectation of margin contraction. Currently, NVIDIA achieves a net margin of 53.4%, compared to around 12% before 2017

Are expectations realistic?

As we've already established, sustaining the current growth rate is not feasible; NVIDIA's customers themselves do not have the growth and resources for it. This fails the first P, it is not possible.

A very strong growth rate of around 22% over an extended period is possible. However, maintaining these very high margins, while possible, seems unlikely to me. Therefore, NVIDIA's current valuation remains in the realm of the second P (Plausible) for me.

Even if these improbably favorable scenarios of margin retention and strong growth unfold, you would still only achieve a return of 6.5% or less on your investment. Is that sufficient compensation for the risks you are taking?