In the spread of the use of artificial intelligence, the first winner appears to be Nvidia, whose capitalisation temporarily exceeded USD 1 trillion. Here, however, it is worth distinguishing between the current valuation and the actual value of the company. The former is determined by the parties to a sale/purchase transaction at the time of its conclusion, while the latter parameter tells us about the company's growth and profit potential over a certain time horizon. The main problem in estimating value seems to be determining the rate of growth (or decline) of future profits, which the market tries to price every day. The question we will try to answer is: how fast would Nvidia have to grow to actually be worth USD 1 trillion?
Discounted Cash Flow Model - DCF
The Discounted Cash Flow (DCF) model, also known as the DCF method, is a financial tool used by investment funds and others to determine the value of assets, mainly companies. The method is based on the projected cash flows generated by an instrument. These are then compared to the present value. This takes into account the time value of money and the required interest rate by investors as a reward for taking investment risk. This risk is measured by the so-called beta, the interpretation of which is very simple. A beta of 1 means that the investment is as risky as the market average.
The DCF model assumes that the value of an asset depends mainly on future cash flows and not on other factors such as market trends (e.g. popularity of a sector) or market volatility.
The analysis can be divided into two stages. The first involves the rapid development of the company over the next 10 years, until the company reaches a dominant position in the market (stable growth). After this stage, even the best companies start to grow more slowly, as most of their potential has already been exploited. What seems relevant in this case is that Nvidia's valuation is $1 trillion, at $403.25 per share.
Source: Conotoxia MT5, NVIDIA, Daily
How fast would Nvidia have to grow?
Although the company's average annual revenue growth over the past five years was 18%, the average annual growth in operating profit over this period was only 10.6%. However, if we focus on the so-called free cash flow (FCFF), we see that it has remained at an unfavourable level since 2020, meaning that the company spends more cash than it generates from its operations.
Source: https://www.discoverci.com/companies/NVDA/free-cash-flow-to-firm-fcff
The discount rate we mentioned earlier is the interest rate demanded by investors as compensation for taking investment risk. According to the Gurufocus portal, the rate expected by investors (taking into account the debt rate) is 16.32% (beta 2.13). After a certain stage of development, when the company has already become large and the growth rate slows down, the expected rate could drop to 10.75% (beta 1.2).
Under the assumptions outlined, Nvidia would reach US$1 trillion, with continued operating profit (EBIT) growth of 82% year-on-year over the next 10 years. This would require the company to grow eight times faster than it has in the past five years. However, such a scenario seems unlikely, regardless of the success of artificial intelligence.
Source: Conotoxia Ltd own analysis
Grzegorz Dróżdż, CAI, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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