After an unbelievable growth run in 2016 for NVIDIA, the graphics specialist’s shares clobbered. They were down 9% when the market closed.
The reason behind this was a double downgrade by an analyst. According to Tech Trader Daily, Romit Shah, an Instinet analyst, he had to drop his rating by about two notches to reduce from buy, and also reduced his target price to $90 from $100. Shah believes that the gaming market, which is the core of NVIDIA, is now meaningfully slowing down and when it is combined with the lofty valuation of NVIDIA, it could become a recipe for grave disappointment according to the current levels. The shares closed yesterday at an amount above $110.
The metric for valuation cited by Shah is to sales from enterprise value and it notes that NVIDIA is now boasting their ratio of EV vs sales, which is now at a 10 year high. The mentioned figure has been averaged at 2x for ten years, but it skyrocketed in 2016. This was what Shah was taking about. The positive sentiment of investors was largely driven due to NVIDIA’s growth in tangential businesses like self-driving cars and data centres whose revenue soared to $487 million or 52% and $830 million or 145% respectively throughout 2016. Even if these businesses are growing nicely, they still are pale in comparison to the company’s core business of gaming in terms of absolute dollars. The revenue of gaming last year was nearly 60% of the total sales or $4 billion.
According to this research note, Shah believed that the market’s implied value ascribed to the emerging businesses is a little unsustainable. This seems to be true if we consider the total implied valuation of what the market’s pricing is into each business. For example, if a multiple of 5x is assigned to the gaming business EV/sales, the valuation would become around $30 billion. Due to this, the automotive and data center businesses combined would be worth $37 billion, according to the estimates by Shah.
Many feel the same as Shah. Although the execution of NVIDIA is incredibly well with their pivots and they continue to put really good results on the board, it seems that the investor sentiment has gotten ahead of itself.
The valuation of NVIDIA is just too massive for comfort as the investors had essentially been pricing in massive growth and flawless execution. It’s not that NVIDIA cannot deliver, but there is a huge risk that it hasn’t been priced properly. There is a pretty good chance of the market being a little overzealous any time we have a stock soar more than 220% in just one year like it happened in 2016.