Nvidia vs. Microsoft stock: Which will be the first $4 trillion company?

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

On Dec. 26, 2024, Apple crossed $3.9 trillion in market capitalization, putting it just 2% away from becoming the world's first $4 trillion company. But it didn't get there. Apple has recovered in recent weeks but remains down big year to date, whereas Nvidia (NASDAQ: NVDA) and Microsoft (NASDAQ: MSFT) just made new all-time highs.

Here's why Nvidia will likely become the first company to surpass $4 trillion in market value, what Nvidia and Microsoft must do to continue rising in price, and whether either growth stock is a buy now.

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A new frontrunner

In less than three years, Nvidia has gone from billions to trillions in market cap. And now, it is the closest company to $4 trillion -- a little over 3% away as of market close on July 3.

NVDA Market Cap data by YCharts.

Nvidia will likely reach $4 trillion before Microsoft simply because it is closer to the threshold, and its stock is more volatile. Nvidia is now up over 18% year to date (YTD), but it was down around 30% YTD in early April during the worst of the tariff-induced sell-off. So it's not unreasonable that the stock could move a few percentage points higher to pole-vault its market cap above $4 trillion.

The better question isn't whether Nvidia or Microsoft will hit $4 trillion in market cap but rather what each company must do to justify that valuation.

An earnings-driven rally

The two biggest drivers of stock-price appreciation are earnings growth and investor sentiment. If earnings are increasing, investors will likely pay a higher price for the company's shares. But if investors expect the pace of earnings growth to accelerate, then they may be willing to give a stock a premium valuation.

Nvidia and Microsoft have been such strong performers in recent years because they are growing earnings and investors are willing to pay a premium price for these companies relative to their earnings. Nvidia went from making under $10 billion in annual net income to a staggering $76.8 billion in just a few years. Microsoft has doubled its net income over the past five years, and its stock price has more than doubled as well.

NVDA data by YCharts.

For Nvidia and Microsoft to continue being good investments going forward, both companies must demonstrate that their earnings growth is sustainable and not temporary.

Nvidia's valuation is still reasonable

Nvidia has greatly benefited from the rapid rise of big tech spending on artificial intelligence (AI). Nvidia has a dominant market share in providing high-powered graphics processing units (GPUs) for data centers and associated AI solutions for enterprises.

Due to limited supply and high demand, Nvidia can charge top dollar for its AI offerings, which allows it to convert over half of its sales into pure profit. And because Nvidia's customers are some of the most financially secure, big-budget companies in the world (like Microsoft), then Nvidia knows its customers can afford to spend a ton on AI.

However, that wouldn't be the case if challenges arise for key Nvidia customers if there is an industrywide slowdown or if competition comes along and erodes Nvidia's margins. Buying Nvidia now is a bet that the company can continue growing its earnings even if its margins gradually decline over time.

The good news is that Nvidia doesn't have to double its earnings every year to be a great buy. Even if it grows earnings at, let's say, 25% per year, it could still reduce its valuation over time and be a market-beating stock. Here's a look at how Nvidia's price-to-earnings (P/E) ratio would go from over 50 to under 35 in five years if it grew earnings at 25% per year, and the stock price gained an average of 15% per year.

Under these assumptions, Nvidia's stock price roughly doubles in five years, but its earnings triple, so the P/E ratio falls considerably.

The key takeaway is that Nvidia doesn't have to sustain its parabolic growth to be a good investment. However, the stock could sell off dramatically if investors believe an unforeseen risk will interrupt its growth trajectory. We got a taste of that in April when Nvidia estimated it would incur multibillion-dollar charges due to tariffs, and the stock price nose-dived in a short period.

In sum, investors should only consider Nvidia if they are confident in sustained AI spending and the company's ability to pivot as the market matures.

Far from a one-trick pony

Microsoft may be a better choice for investors seeking a more balanced tech stock to purchase. Microsoft has a lower P/E than Nvidia, and for good reason, because it isn't growing as quickly. However, Microsoft also doesn't need a lot to go right for it to continue growing steadily over time.

The vast majority of Nvidia's earnings are directly tied to AI. Microsoft has a diverse earnings profile, encompassing cloud computing, software, hardware, platforms such as GitHub, LinkedIn, and Xbox, as well as other areas. AI is accelerating Microsoft's earnings growth and expanding its earnings, but the company can still do extremely well even if AI investment slows and the industry matures.

It's also worth mentioning that Microsoft routinely buys back its stock and has raised its dividend for 15 consecutive years. So it has a more balanced capital-return program than Nvidia, which rewards shareholders by growing the core business rather than directly returning capital.

Two solid buys for long-term investors

Nvidia and Microsoft are exceptional companies. It wouldn't be surprising to see them both surpass $4 trillion market caps and continue building from there. However, investors should be mindful that both companies are seeing their stock prices rise faster than their earnings are growing, which puts pressure on them to bridge the gap between expectations and reality.

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.