Nvidia Is Far Behind These 3 Semiconductor Stocks In 1 Key Metric — Is the AI Growth Stock Still a Buy? | The Motley Fool

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Does this valuable metric show that the artificial intelligence leader’s stock has gotten too hot to handle?

Nvidia (NVDA 2.20%) has been one of 2023’s hottest stocks. Thanks to some fantastic business results and excitement surrounding the artificial intelligence (AI) revolution, the company’s share price has soared approximately 213% this year.

But with such stellar stock performance, questions have also risen about the company’s valuation. Take a look at the following chart that compares Nvidia’s free-cash-flow (FCF) yield to some other leading players in the semiconductor space, and read on for a deeper dive as to what it means for investors.

The data used in the chart provided above was sourced by New Constructs — a data specialist that dives into financial statements beyond GAAP results. In order to calculate free cash flow, New Constructs uses a more orthodox method by taking a company’s net profit after taxes and subtracts the changes in net working capital (excluding excess cash) and the change in fixed assets. Notably, this differs from the more generic approach to calculating free cash flow formula that involves subtracting capital expenditures from operating cash flow.

To get the FCF yield, free cash flow is divided by the company’s enterprise value — which is calculated by adding a company’s market capitalization to its debt and then subtracting the value of its cash and short-term equivalents.

Of the semiconductor companies tracked in the chart, Nvidia has a higher FCF yield than only two companies — AMD and Intel. Even then, it only edges out AMD by a relatively small margin. Meanwhile, Broadcom, Qualcomm, and Taiwan Semiconductor Manufacturing have far higher FCF yields than Nvidia.

Relative to its current valuation levels, Nvidia is serving up far less free cash flow than some other leading semiconductor companies. On the other hand, relying on an apples-to-apples comparison of these companies along FCF yields probably isn’t sensible and shouldn’t be relied on to suggest how the stock will perform over the long term.

Nvidia, AMD, Intel, Broadcom, Qualcomm, and TSMC all operate in the semiconductor industry, but their respective businesses and product offerings differ in big ways. In terms of product offerings, Nvidia is most similar to AMD because both companies are leading players in the graphics processing unit (GPU) space. But they’re still very different because Nvidia dominates the GPU market for data centers and AI applications — and because AMD also generates much of its revenue from CPU sales.

Meanwhile, Taiwan Semiconductor Manufacturing has a specialized business that revolves around fabricating other companies’ chip designs. Intel designs and manufactures its own chips, but its product offerings are significantly concentrated in the central processing unit (CPU) market. Meanwhile, Broadcom has a big presence in networking chips and a sizable software component, and Qualcomm designs processors and connectivity chips for mobile hardware.

Across the various product and service categories that these semiconductor companies operate in, growth rates are going to be very different. Of these leading chip giants, Nvidia currently has the most promising growth outlook. While the company currently has a much lower FCF yield than some other semiconductor players, it makes sense that it’s being valued at a premium.

In the first half of this year, Nvidia’s free cash flow quintupled to reach $8.69 billion. This kind of growth almost certainly won’t be sustainable, but the company’s market capitalization doesn’t look ridiculous in the context of its recent FCF momentum and long-term expansion opportunities.

Because Nvidia’s market capitalization has more than tripled this year to climb above $1.13 trillion, its FCF yield has been tamped down. On the other hand, it’s probably fair to say that no other leading chip company has a more exciting growth outlook right now.

Amid rising demand for AI and accelerated computing technologies, demand for high-performance GPUs will see strong growth — and Nvidia is the clear leader in the category.

Investors who are more risk-averse may find it more suitable to back companies with higher FCF yields and less growth-dependent valuations, but that doesn’t mean Nvidia is a bad buy. The GPU leader is spearheading the AI revolution, and there’s a good chance that it will deliver fantastic long-term returns if it holds onto its category-leading position.

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