NVIDIA has been making the news in recent days after it released its first-quarter earnings. It saw a 14% increase in revenue year-over-year in its data centre business thanks to the explosion of generative AI, which its hardware largely powers.
The news propelled NVIDIA’s stock price by about $80 in one day and the company’s total market cap almost surpassed $1 trillion, which, if it had passed, would have put it in a very special club with Apple, Microsoft, Saudi Aramco, Alphabet, and Amazon.
In this editorial, I want to run NVIDIA’s financials through two valuation methods I like for approximating a company’s fair or intrinsic value. It should be noted that they are fairly conservative valuation techniques but we can do a quick trick to help account for all the hype surrounding NVIDIA, and the subsequent demand that makes the price of the stock that much higher.
It should be said that nothing I outline below constitutes investment advice, furthermore, I do not own NVIDIA stock nor am I shorting it. Both the valuation methods, the Graham Number and Book Value Per Share are well-known methods for valuing companies’ share prices, and both are quite conservative. Do not buy or sell NVIDIA stock solely on these valuations.
Graham Number
The first valuation method I want to look at is called the Graham Number. The name may be familiar to you if you’ve ever listened to Warren Buffett talk. It’s named after his mentor Benjamin Graham, a proponent of value investing (where you buy underpriced stocks with the expectation that they’ll go back up to their fair value).
The Graham Number formula outputs the most a value investor should pay for a stock. Ideally, a value investor would want to buy the stock for 20% or more below the Graham Number to give themselves a margin of safety.
With very popular stocks like Google, Tesla, Meta, and NVIDIA, you’ll often see that the sheer demand for these stocks rockets their price well above the Graham Number so a trick can be used where you multiply the Graham Number by four just to account for all the demand.
Obviously, this is a bit precarious for people after value stocks but in the case of NVIDIA and similar stocks, they may never get close to their actual Graham Number, due to demand.
So, how do you work out the Graham Number? The formula is:
SQRT(22.5 x (earnings per share averaged out over three years) x (book value per share))
If we use the latest data from Yahoo! Finance, we could tap into a calculator:
√(22.5×((1.74+3.85+1.73)÷3)×(8.96))
to get the result of $22.17. According to the Graham Number formula, the fair value of an NVIDIA share is $22.17 – compare that to the value it’s trading at currently of $379.80 per share. If you multiply this by four to try and account for hype, you still only reach $88.71.
Book Value Per Share
Earlier, I referred to the Graham Number and Book Value Per Share as conservative valuation tools. It would be more proper to call the Book Value Per Share ultra-conservative.
The Book Value Per Share is how much a shareholder would theoretically be paid out if a business sold all of its assets, paid its debts, and distributed the rest of the money to its shareholders.
You can work out the Book Value Per Share by subtracting the company’s total liabilities from its total assets and then dividing the answer by the outstanding shares – it’s also readily available on websites like Yahoo! Finance. In the case of NVIDIA, it has a Book Value Per Share of $8.96.
The Book Value Per Share is far too conservative for valuing NVIDIA, the demand for the stock pushes it well above this figure. Intel has not been doing well recently in terms of its stock price and it is still hovering above, just slightly, its Book Value Per Share.
Bonus: Price/Earnings to Growth Ratio, P/E Ratio, DCF
While digging out the numbers for the Graham Number, I happened upon NVIDIA’s Price/Earnings to Growth Ratio. This is similar to the price-to-earning (P/E) ratio but also factors in the future expected growth of a company.
The magic number when it comes to the PEG ratio is 1.0, if it’s below this, it can indicate a stock is undervalued and if a stock is higher, it can indicate that it’s overvalued. Using the 5-year expected growth rate, Yahoo! Finance says NVIDIA’s PEG ratio is 3.55, meaning it’s trading at 3.55 times its expected earnings growth rate, again suggesting it’s overvalued.
If NVIDIA had a PEG ratio of 1.0, it would be trading at $107.04 – this could be taken as a possible fair price.
Going back to the P/E ratio mentioned earlier, Yahoo! Finance says that NVIDIA’s P/E ratio is at a huge 218.28. For comparison, the S&P 500’s long-term average P/E ratio is about 16, which suggests NVIDIA could be overvalued.
Aside from the valuation methods used above, there’s also a common one you’ll see online called Discounted Cash Flow (DCF). This method attempts to work out the fair value today based on future expectations. The trouble with this method, of course, is that nobody can predict the future.
Alpha Spread, which offers DCF valuations lists worst, base, and best case valuations which it lists as $44.55, $80.51, and $226.81, respectively. A similar website, GuruFocus suggests a DCF fair value of $59.87. So as you can see, it’s a bit all over the place, but well below the current levels.
Conclusion
Over the long term, NVIDIA and other tech stocks will probably grow as they develop new technologies and increase their portfolio of products and services. In the short and medium term, however, NVIDIA could experience a bit of a pullback so it’s best to be careful if you were thinking of jumping in right now.
One of the things that the investor Charlie Munger says is that you should look for great companies at a fair price, as opposed to fair companies at a great price. NVIDIA is a great company, but with the huge price explosion, I don’t think it’s currently trading at a fair price.
If you are thinking about investing, you should not only use these valuation methods, they should be used within a more comprehensive system for evaluating stocks. As I’ve said with other types of investing in the past, if you decide to have a go, only invest what you can afford to lose, or you might end up like this guy.
The views, opinions, positions or strategies expressed by the author and those providing comments are theirs alone, and do not necessarily reflect the views, opinions, positions or strategies of Neowin.