I’ve gotten a lot of questions about how Nvidia’s stock price could have dropped after reporting earnings that beat estimates. Over the short-term, stock prices move based on market psychology and emotions, and few stocks generate the emotional response Nvidia. The company has reported some of the most dramatic earnings beats that I’ve ever see over the last 18 months or so. Investing in stocks is not about predicting short-term earnings. As value investors, we try to buy businesses at large discounts to intrinsic value. By doing this we are positioning ourselves where we have the expectation to profitably invest, and we are also creating a strong margin of safety, so that even if our forecasts are overly optimistic, we have a layer of protection.
Aswath Damadoran teaches corporate finance and valuation at NYU and is quite brilliant in my estimation, definitely smarter than me. In Damadoran’s optimistic forecast for Nvidia, he assumes revenue will grow from $96.3B to $422.7B in ten years, which equates to a compound annual growth rate of 16%. Then he assumes some regression in EBIT margin down to 60%, while the company maintains a return on invested capital of 130% over the 10 years. These are metrics that any company would love to achieve. Even with this phenomenal performance, Damadoran’s fair value estimate for Nvidia would only be $87, which is quite a large discount from today’s price of $106. This doesn’t mean that he is right, or that Nvidia can’t rally to $200. It just means that the current valuation assumes incredibly optimistic assumptions that have historically been very hard to achieve. This is the same dynamic which we saw when Tech busted in 2000. Microsoft and Cisco still had amazing businesses, and the businesses produced great profit growth. However, the valuations at that time were so excessive, that Microsoft investors had to wait 13 years to get back to even, while Cisco investors still haven’t gotten there. Because stocks like Nvidia now have such a huge weighting in the indices, these factors could cause the indices to have drastically worse performance than the previous 10-15 years, when we were recovering from the lows of the Great Recession.
Here is a link to Damadoran’s analysis of Nvidia
Here is a link to our recent research report on WPC