This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
There are no guarantees in investing. That's the hard truth we all have to learn. Some investments come with low risks, while others have a high risk of not working out, but none come with zero risks.
When you buy a stock, you need to weigh its potential upside and money-making potential without ignoring the downside.
Today, many people are divided over Nvidia (NASDAQ: NVDA). After rocketing higher in the last few years and becoming one of the largest companies in the world by market value, bulls are pounding the table that the party will continue in 2025.
Bears are calling for a crash in Nvidia stock and think it is overvalued. While both sides will talk with certainty, it's impossible to guarantee what will happen with Nvidia in 2025. If it's possible the stock will surge higher or crash, what's the likelihood of either scenario?
Using history as a guide, let's try to figure out the likelihood of an Nvidia stock crash in 2025 and whether you should buy shares of the stock for your portfolio today.
Decades of history for a cyclical company
Nvidia has been one of the best-performing stocks in the last few decades. Shares of the stock are up 335,000% since going public in 1999, or a compound annual growth rate (CAGR) of 30%.
However, there have been multiple stock crashes along the way. If we define a stock crash as a drawdown of 50% or more, Nvidia has gone through four stock crashes since going public: 2001, 2008, 2018, and most recently in 2022. Yes, it was just a few years ago that Nvidia was disliked by the investment community.
Why such erratic behaviour from investors? Well, for one, this is how markets tend to operate, even for the best businesses in the world. Two, Nvidia operates in the cyclical semiconductor industry. A cyclical industry is one with inconsistent end-market demand from customers, which causes volume fluctuations and volatility in the income statement.
Semiconductors are cyclical because of inconsistent demand from computer chip buyers. You can see this in Nvidia's revenue chart, which has periodic dips and revenue declines.
It has been 26 years since Nvidia went public, and the stock has crashed four of these years. So, it's certainly possible that Nvidia's stock price will reverse and turn south in 2025.
In fact, I think 2025 is a year that is more likely than most of a drop in stock price. Here's why.
A profit margin jump to stay cautious about
When looking at a stock that operates in a cyclical industry, you need to try to analyse what part of the cycle we are in. For Nvidia, we are definitely in an uptrend in the cycle. Revenue is soaring on the back of new demand in artificial intelligence (AI).
Perhaps more importantly, its operating margin is at an all-time high of 63%, which shows that the company is implementing sizable price increases due to what seems like insatiable customer demand for its AI products.
Eventually, Nvidia's supply of semiconductors will balance out with customer demand. This will lead to price stabilization, slowing revenue growth, and perhaps a turning of the semiconductor cycle (at least in Nvidia's niche). That doesn't mean that it's a guarantee that Nvidia's revenue will turn over in 2025, but it isn't impossible. It has happened multiple times in the last 25 years, usually following periods of soaring revenue.
This is the nature of investing in a cyclical industry. Revenue may go up over the long term, but there will almost assuredly be lumps along the way.
NVDA Operating Margin (TTM) data by YCharts
Should you buy Nvidia stock?
At today's stock price, Nvidia has a market cap of $3.5 trillion. It has a price-to-earnings ratio (P/E) of 54, which is close to twice the level of the S&P 500 index's average P/E of 30.
I think it is likely that Nvidia's revenue will grow over the long term, which should lead to earnings growth. But today the company is sporting a record operating margin that will likely revert back to a lower level once this AI boom levels off.
If supply catches up with demand -- as it always eventually does in semiconductors -- then Nvidia's selling prices and profit margins per chip are likely to fall. This would create a double whammy of earnings headwinds from lower revenue and lower profit margins.
Nvidia currently has a net income margin of 55%, leading to $63 billion in earnings on $113 billion in revenue. If revenue goes through a downcycle in 2025 and falls to $100 billion but profit margins slip back to 40%, its net income will fall to $40 billion. Compared to a market cap of $3.37 trillion, that is a nosebleed P/E ratio of 84. Nvidia's stock is likely lower in this scenario.
This is a great business, but one trading with sky-high expectations and a chance for a cyclical downturn to occur in the near future. Skip out buying Nvidia stock today. If you like the company and think it is a great business, wait and buy during the eventual cyclical downturn for the semiconductor market, not close to the peak.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
