As investments in artificial intelligence (AI) gain momentum, the trend is becoming more and more similar to other bursting bubbles. I often hear people say, “This time it’s different!” In reality, history doesn’t often repeat itself, but it does rhyme.
So if you invest in AI stocks, you need to be aware of the bubble risk and what to do if the company you invest in goes boom.
Consider the case of Zoom video
The toughest challenge for many investors during a bubble is understanding when companies are performing and driving share price performance relative to mere expectations. Even more confusing are companies that have all their cylinders running but are trading at ridiculous valuations with no way to make a profit on their investment.
Let’s take a look at the work-from-home stocks that made similar moves in 2020 and 2021 until they crashed to Earth in 2022. Typical examples of working from home are: Zoom video communication (ZM -1.23%). Demand for Zoom has surged since the pandemic forced businesses to adopt remote work. The company’s valuation continued to rise as it turned that interest into earnings.
ZM PS Ratio data by YCharts.
By mid-2021, the company will be at about 35x revenue and a profit margin of about 30%, and to achieve 30x profit, the usual valuation for a software company, it will take about 30x revenue over the next five years. should be increased by 250%. It’s not impossible, but it’s not easy to achieve. But even if Zoom did that, the stock wouldn’t have gone up. That was my prediction in advance.
Understanding a stock’s valuation is very important because it tells you what to expect from that stock. Next, we need to estimate the duration of these goals. If you give up a year or two of returns in exchange for a big uptick after that, the stock might make sense to invest in. But if he has to survive five years of rapid growth for the stock to reach a reasonable valuation, then there may be too much hype built in.
Nvidia has very high expectations built in
Unfortunately, this is already being seen in many AI-centric stocks.and Nvidia (NVDA -1.90%) Sales are 41x, about the same as Zoom. The company forecasts a staggering 64% growth in the second quarter of fiscal 2024, but that growth will have to continue well beyond this year for the valuation to make sense.
Even if Nvidia hits the average analyst revenue forecast of $54.5 billion for the 2025 fiscal year (ending January 2025), it’s going to hover at 19x revenue. If Nvidia were to return to its peak profitability of 35% margins, the stock would trade at 54 times his P/E ratio, which would still be an expensive valuation.
Moreover, we are now in an even more precarious situation. Zoom operates on a subscription model and offers some degree of business continuity, while Nvidia’s product is more discretionary in nature. Sure, Nvidia also has a subscription business aspect to it, but once a customer builds his AI infrastructure, it’s unlikely he’ll continue to buy Nvidia’s GPUs for him at the same pace he’s doing now.
So if you’re considering investing in AI stocks, understand what growth and profitability a company needs to achieve within a specific timeframe for the investment to be meaningful. To do so, run your future enterprise through valuation analysis.
Growth companies almost always pay some premium, but the question is how much is reasonable? It varies from investor to investor (because everyone has different return goals and time horizons), but expecting a positive return after two or three years seems like the bare minimum to me.
Keep this in mind when investing in AI, as while a few companies will emerge as long-term winners, many others fail to meet the expectations championed by management. There are many great AI investments out there, but you should do your homework first before investing.
Keithen Drury holds a position at Zoom Video Communications. The Motley Fool has positions with and endorses Nvidia and Zoom Video Communications. The Motley Fool has a disclosure policy.
