What The Nvidia Downgrade Means For The AI Bubble

Nvidia Corporation (NASDAQ: NVDA), the poster child of the AI stock rally, received a rare Wall Street downgrade last Friday when New Street Research published a report claiming that the company’s current market value reflects its economic reality, suggesting the upside will be limited from here on. The research firm has a 12-month price target of $135 for Nvidia, which is derived using a forward earnings multiple of 35. New Street analyst Pierre Ferragu, despite downgrading Nvidia, still believes that the company is a great business but claims that he will only upgrade the stock to a buy rating if the stock price weakens meaningfully from the current levels, resulting in a higher margin of safety.

Is There Really An AI Bubble?

AI stocks, led by Nvidia, have fueled the stock market rally since the beginning of 2023. Certain indicators suggest that AI stocks may be in a bubble similar to how Internet companies formed a bubble in the late 90s before bursting in 2001. The top 10 companies in the S&P 500 Index make up 35% of the index’s market capitalization today, but these companies account for just 23% of total earnings. This suggests there is a disparity between the market value and corporate earnings of S&P 500 constituents. The stellar performance of Tech/AI stocks such as Nvidia, Microsoft Corporation (MSFT), and Alphabet Inc. (GOOG) have played a part in creating this anomaly.

According to James Ferguson, founding partner of MacroStrategy Partnership, AI stocks are trading at dangerously high valuation levels given that most use cases of AI technology remain unproven today.

Looking To The Future

Nvidia stock is up a staggering 3,000% in the last 5 years, and this exponential growth has given rise to speculation that the stock is in a bubble today. However, the analyst sentiment on Nvidia is a mixed bag given that the company has reported strong earnings growth during this period. For instance, in Fiscal 2024 which ended in January, the company reported a YoY growth of 125%. Net income for the same period jumped more than 500% compared to the previous year, which confirms that Nvidia’s stock market rally has been supported by strong financial performance.

Contrary to New Street’s belief that Nvidia is fairly valued today, UBS analysts believe the company is well-positioned to see strong growth aided by the robust demand for Blackwell chips. Analyst Timothy Arcuri sees Nvidia’s earnings per share rising to $5 by 2025, up from just $1.71 reported for the last 12 months. Based on these expectations, he raised the price target for Nvidia from $120 to $150.

Based on the ratings of 41 Wall Street analysts, the average Nvidia price target is $136.49, which implies an upside potential of just 5% from the current market price.

Dilantha DeSilva holds positions in Microsoft. Stocks.News holds positions in Microsoft and Google.