Is this a tech bubble?

Last week, NVIDIA (NVDA) briefly surpassed Microsoft (MSFT) to become the world’s largest company and a component of the S&P 500 index. Though it retreated from that position over the weekend, now seems like an appropriate time to reexamine whether big tech stocks, and NVIDIA in particular, are in the midst of an unsustainable bubble.

The Magnificent 7, comprised of Microsoft (MSFT), Meta Platform (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), have grown to more than 32% of the market cap of the S&P 500. Of the Magnificent 7, only Tesla is not in the top 10 of the S&P 500. Seven of the top 10 companies in the S&P 500 are technology companies, including Broadcom (AVGO).

NVIDIA is of particular interest as its market cap has grown substantially on the back of a wave of spending on artificial intelligence, now exceeding $3.1 trillion. This, along with its recent brief rise to the top of the S&P 500, makes NVIDIA the company of choice for this analysis.

For the purposes of this analysis, a “bubble” is defined as a stock price that cannot be justified by anything other than the fundamental earnings strength of the company. Based on trailing 12-month earnings and consensus earnings forecasts for next year, the Magnificent Seven stocks all have price-to-earnings ratios that beat the S&P 500. While this ratio indicates that these companies are richly valued, it is unclear whether other factors justify the premium.

Another way to value a company is by its earnings over its sales, known as its price-to-sales multiple. The Magnificent Seven are all valued at price-to-sales multiples above the S&P 500, with NVIDIA boasting an astounding price-to-sales multiple of over 40x.

Annual growth in sales over the past three and five years has been impressive for most of the group.

Similarly, in a case like NVIDIA, historical earnings per share growth has generally been impressive and exceptional.

The five-year annualized earnings per share growth rates of the Magnificent Seven companies show just how unique these companies are compared to the stock market as a whole.

Future earnings are the most important criterion when considering buying or holding a stock. Consensus forecasts by Wall Street analysts are fairly optimistic about NVIDIA’s earnings growth prospects. Apart from that, the group’s so-called sustainable growth rate supports the future growth story. The sustainable growth rate theoretically indicates how fast a company could grow without borrowing additional funds and using the same capital structure.

Again, most of the profitability metrics for the Magnificent 7 companies are impressive. Gross profit looks at profitability after all direct expenses, defined as cost of goods sold, are subtracted from sales. Operating profit measures how much profit a company makes on a dollar of sales after paying variable costs, or the percentage of sales that converts into operating profit. NVIDIA converts nearly 60 cents of every dollar into operating profit, putting it at the top of the Magnificent 7 companies.

Warren Buffett argues that when analyzing companies with high return on invested capital (ROIC), you can’t rely on a simple high price-to-earnings ratio. He says, “I like stocks that have a high return on invested capital and a good chance of continuing to have high earnings in the future. For example, the last time I bought Coca-Cola, it had a price-to-earnings ratio of about 23 times. If you add up the purchase price and current earnings, it’s about 5 times. It’s the interaction of invested capital, return on capital, and future capital generated and the current purchase price.” To put the Magnificent 7 return on invested capital figure in proper perspective, the S&P 500 has an ROIC of about 8%.

Additionally, most of the Magnificent 7 companies generate significant amounts of free cash flow, even as they invest in their growing businesses. Free cash flow margin measures the percentage of revenue that a company converts into free cash flow that it can use or distribute to shareholders. NVIDIA is an exception, converting nearly half of its sales into free cash flow.

Charlie Munger also places a premium on cash flow over other valuation metrics, stating, “We try to stick to companies that are flush with cash flow. We don’t think about value as a low price-to-book ratio or a low price-to-earnings ratio. We value companies on their cash flow, just like private equity investors do. We value companies on their cash flow.”

Free cash flow yield is the free cash flow per share that a company generates expressed as a percentage of its stock price. Free cash flow yields below the S&P 500, like those of Magnificent 7 and NVIDIA, indicate that investors are already pricing in superior free cash flow growth and sustainability relative to the market.

Investors are already appreciating Magnificent 7’s strong fundamentals, with its year-to-date price-to-earnings multiples for 2023 and 2024 well ahead of the S&P 500.

Despite the massive outperformance of tech stocks, the evidence that we are not in a bubble is almost undeniable. Large tech stocks are generally very profitable relative to the average stock and should trade at a premium valuation. The Magnificent 7 stock price rally is supported by solid fundamentals as well as the promise of future profitability.

The bullish view on big tech companies and NVIDIA is strengthened by the rise of artificial intelligence (AI). AI seems likely to become a transformational tool that will generate significant economic benefits for companies. The complex calculations required to support AI are typically done by cloud service providers (CSPs). JP Morgan predicts that technology spending by the top four U.S. CSPs will be around $150 billion in 2024, up 39% from 2023. NVIDIA, as the leading chip provider for AI, should reap significant revenue from this spending.

Conversely, the risks of holding stocks of these tech companies, including NVIDIA, are increasing. The bullish case is well known, and there is always the possibility that capital spending on AI will exceed end demand for services, leading to layoffs or that the technology will fail to live up to expectations. Moreover, the phenomenal profitability of a company like NVIDIA is difficult to sustain over the long term, as capitalism puts companies in fierce competition for profits. Investors buy or hold companies for their future profits, not their past profits. The past is only important if it indicates a company’s future prospects. Companies like many of the Magnificent 7 have shown superior profitability over time, which is evidence of a competitive advantage and should allow them to capture excess profits. Still, that possibility must be balanced against the price paid.

Mega-cap technology stocks, such as the Magnificent 7, continue to generate earnings and free cash flow at an impressive pace. These are generally noteworthy companies with very strong returns on capital, but selective stock divestitures are considered prudent risk management even if there are no current signs of trouble. Selective buying in underperforming, less cyclical sectors such as healthcare and consumer staples provides an attractive counterweight to performance and risk concentration in the technology sector.