is Nvidia Overvalued? The Generative AI Bubble and Nvidia’s Stock: An Impending Burst?

September 1, 2023

Historically, financial markets have witnessed numerous asset bubbles, from the Tulip mania in the 17th century to the more recent Dot-com bubble in the late 1990s and early 2000s. Each bubble shares a common storyline. Firstly, irrational exuberance around a particular asset class. Secondly, driving prices to unsustainable levels. Thirdly, followed by a sharp and often painful correction.

1636 Tulip Bubble : GameStop, Crypto & Social Media

Nvidia’s recent stock performance, driven by the enthusiasm surrounding generative AI and soaring earnings, seems to exhibit many characteristics of such speculative bubbles. We think Nvidia is a great company. See our piece: AI Gaming Dominance. Howeer, just maybe at $300 a share. See A Detailed Valuation Analysis (yahoo.com) for a good walk through of the numbers!

Now, let’s delve into the overall factors that suggest Nvidia’s stock surge might become another bubble waiting to burst?

Especially in the context of historical price-to-earnings (PE) ratios and a rising interest rate environment.

Generative AI’s Unrealistic Hype:

Generative AI, which encompasses technologies like GANs (Generative Adversarial Networks). Moreover, became hailed as the next frontier in tech innovation. While its applications, ranging from image generation to enhancing video game graphics, are genuinely groundbreaking, the commercial viability and scalability of these applications remain in question. The hype is currently outpacing the practical and profitable applications of generative AI. Much like the Dot-com bubble, where companies with little more than a website and a vision saw their valuations skyrocket, the fervor around generative AI might be inflating Nvidia’s stock beyond its genuine value. See: Cathie Wood Says Every Stock Could Become An AI Stock. What does that mean? Or does it simply represent the irrational exuberance occuring presently?

Nvidia’s Historical PE Ratios:

Price-to-earnings ratios are a standard metric to determine a company’s stock value concerning its earning power. Historically, Nvidia has not sustained PE ratios above 50 for extended periods. Such ratios suggest that investors are willing to pay a significant premium for the company’s future earnings, indicating heightened expectations. If Nvidia fails to meet these lofty expectations, a correction could be imminent.

The Rising Interest Rate Environment

The Federal Reserve’s stance on raising interest rates can’t stand ignored in this discussion.

In a low-interest-rate environment, equities like Nvidia become more attractive as the returns from safer assets, such as bonds, diminish. However, as the Fed pivots towards higher interest rates, bonds and other fixed-income instruments become more appealing, potentially leading to a capital flight from equities.

Higher interest rates also impact companies operationally. They increase borrowing costs, potentially affecting profitability. For tech companies with high valuations predicated on future growth, this can be especially concerning. Reduced profitability and the consequent inability to finance growth can lead to a reassessment of the company’s valuation, triggering a stock price decline.

The Tech Sector’s Vulnerability

The tech sector, especially companies at the forefront of emerging technologies, is notoriously volatile. These stocks often have valuations heavily reliant on future growth projections. Any change in the broader economic environment, regulatory landscape, or even market sentiment can lead to significant price swings. Nvidia, being a pivotal player in the tech space, is not immune to these dynamics.

In conclusion, while Nvidia is undoubtedly a market leader and continues to innovate in the realm of AI and graphics processing, the current exuberance around its stock, fueled by the generative AI bubble, may not be sustainable in the long run. With historical PE ratios as a reference and the looming shift in monetary policy, investors should tread with caution. Like every bubble that has come before, the factors leading to its rise often sow the seeds of its eventual burst.