Why Nvidia's longer-term future return is not worth the risk - even if it continues to be a phenomenally profitable company.

Nvidia Corp.'s market performance over the past six months is a good illustration of the difference between a good company and a good stock.

Nvidia - the company - has performed phenomenally. Its cumulative earnings per share over the past two quarters were more than 800% higher than the comparable two-quarter total a year earlier. Yet Nvidia's stock $(NVDA)$ fell after the company's earnings report last week.

The reason is that investors last summer were pricing Nvidia's stock for perfection. This shows how forecasting a company's earnings prospects is only half the battle when assessing whether its stock is a good bet. A great company whose stock is overvalued can still be a big disappointment.

Qualcomm Inc. $(QCOM)$ is an even starker example of how good news gets priced in with predictions for a stock's performance. Imagine someone in early 2000 who was eager to invest in the company's stock because it would be phenomenally profitable over the next two decades. That would have been the right call, since Qualcomm's earnings over the next 23 years grew 60-fold (according to calculations from investment firm Research Affiliates). Yet Qualcomm stock's over that time was a loser, producing a return of just 2.8% annualized - well below the U.S. market's return.

Use P/E ratio for a reality check

There are myriad ways to assess a company's valuation. One of the simplest is the price/earnings ratio. Take the rate of return you expect from a company's stock, then estimate its future earnings per share. You can then calculate the implied future P/E ratio and assess whether that ratio is realistic.

While exuberant investors may not have a specific rate of return in mind when betting on highflying stocks such as Nvidia, behavioral research has found that they typically extrapolate the recent past into the indefinite future.

For illustration purposes, let's assume you expect a continuation of Nvidia's stock performance shown over the trailing 12 months, which is 58.0%.

The next step is to get an estimate of Nvidia's future profitability. Let's assume Wall Street's consensus expectation, which according to FactSet is that the company's earnings-per-share (EPS) will be $8.10 in 2030. This is a generous assumption, as Wall Street analysts are typically too optimistic; that estimate represents a nearly 600% increase over the $1.19 EPS the company reported in 2024. If the consensus comes even close to being correct, Nvidia's status as a phenomenally successful company would be further enshrined.

Still, Nvidia's stock is unlikely to live up to an exuberant investor's return expectation. Given these two assumptions, Nvidia's stock would have a P/E in 2030 of 146 - versus 42.5 currently. Such a high P/E ratio is unrealistic since hardly any mature large-cap company has traded at that high of a P/E ratio (except temporarily, when coming out of an earnings slump). Due to the law of large numbers, a large-cap company can't continue to grow at the triple-digit percentage pace it could as a smaller company. Bear in mind that Nvidia is currently a $3 trillion company, versus $12 billion a decade ago.

For a related reality check, estimate what you think Nvidia's P/E ratio will be in five years' time and calculate the rate of return that estimate implies. For reference, consider that the average forward P/E of the so-called Magnificent Seven stocks (other than for Tesla $(TSLA)$, whose profitability has been declining) is 28.2 (according to Yahoo estimates).

It would be generous to assume Nvidia's P/E will be that high in 2030, since many worry that the Magnificent Seven stocks are overvalued. Even so, on the assumption that 28.2 will be Nvidia's P/E in 2030, its stock between now and then would produce a 13.0% annualized return - decent but not enough to beat the market on a risk-adjusted basis.

To be sure, you will never be able to have 100% confidence in your projections. Investing is a game of probabilities, not certainties. Still, it's possible to triangulate on increasingly realistic projections of a stock's likely future performance. With Nvidia, you will likely conclude that a realistic estimate of Nvidia's longer-term future return is not worth the risk - even if it continues to be a phenomenally profitable company.