Last week, NVIDIA briefly surpassed Microsoft as the largest company in the world and the S&P 500 index, sparking discussion about whether the large technology stocks, including NVIDIA, are in a bubble. The Magnificent 7, which includes companies like Meta Platforms, Amazon, and Apple, make up over 32% of the market capitalization of the S&P 500, with only Tesla falling outside the top ten companies in the index. NVIDIA in particular has seen a massive increase in its market capitalization, now exceeding $3.1 trillion due to the artificial intelligence spending wave. While it slipped from the top spot last week, the focus is now on whether this surge in tech stocks is sustainable or a bubble waiting to burst.
When analyzing whether a stock is in a bubble, one key indicator is the price-to-earnings ratio, which compares a company’s stock price to its earnings. The Magnificent 7 all have price-to-earnings ratios above the S&P 500, indicating a higher valuation. Another metric to consider is the price-to-sales ratio, with all the Magnificent 7 valued at ratios above the S&P 500, with NVIDIA notably having a price-to-sales ratio of over forty times. Despite these high valuations, the historical growth in sales and earnings per share for most of these companies has been impressive, especially for NVIDIA, setting them apart from the broader stock market.
Looking at future earnings prospects, Wall Street analysts show significant optimism for NVIDIA’s growth potential, supported by the sustainable growth rate for the group. The profitability metrics of the Magnificent 7 are also strong, with companies like NVIDIA boasting impressive gross and operating margins, highlighting their ability to generate profits. Figures like return on invested capital and free cash flow margins also indicate the financial stability and growth potential of these tech giants.
Investors have already priced in the strong fundamentals of the Magnificent 7, with stock returns outstripping the S&P 500 in recent years. Despite concerns about a potential bubble, the evidence suggests that the current situation is not unsustainable. Large technology stocks generally have exceptional profitability and should trade at a premium valuation, supported by robust fundamentals rather than speculation about future profitability. The rise of artificial intelligence is also seen as a significant opportunity for companies like NVIDIA, with AI expected to generate substantial economic profits and drive tech spending by cloud service providers.
While the bullish case for large tech stocks like NVIDIA is strong, there are also risks to consider. The possibility of capital spending on AI outpacing demand or the technology failing to deliver on its promise could impact the profitability of companies in the sector. Maintaining eye-popping profitability over the long term is a challenge, as companies face fierce competition and evolving market conditions. Despite the impressive financial performance of the Magnificent 7, prudent risk management suggests that selective pruning and diversification into underperforming sectors may be a wise move for investors to balance their portfolio and mitigate concentration risk.
