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Nvidia Stock Is a Strong “Sell” Following the Arm Deal Collapse

InvestorPlace - Stock Market News, Stock Advice & Trading Tips NVDA stock was already overvalued, and the failure of its Arm Holdings deal will only make a difficult situation even...

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This story originally appeared on InvestorPlace

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

Investorplace.com - InvestorPlace

Nvidia (NASDAQ:NVDA) has been one of the biggest winners of the past five years, with NVDA stock up nearly 890%. The company has enjoyed a variety of tailwinds, including a historic semiconductor boom, the crypto mining explosion, and surging demand for graphics chips for other applications such as gaming.

Source: sdx15/Shutterstock

However, like many momentum trades, folks took NVDA stock too far. While Nvidia's business improved dramatically over the past few years, its stock price ran far ahead of fundamentals. NVDA stock hit a breathtaking high of $346.47 in November.

Even after its recent pullback, the stock is still trading above $265, which amounts to a stunning price-to-sales ratio of 25. In a tech bear market, there's simply no margin of safety whatsoever in buying a company like Nvidia at such a massive multiple.

And the one potential justification for Nvidia's inflated stock price, its upcoming merger with Arm Holdings, got called off last week. With regulators rejecting Nvidia's efforts to take over the semiconductor and software design company, it's hard to see any path to Nvidia maintaining its super-premium valuation.

Arm Deal Failure Represents a Significant Setback

Nvidia planned to pay approximately $40 billion to purchase Arm from Softbank. This would have been the biggest deal in the history of the semiconductor industry.

Arm does business with a vast array of customers including Apple (NASDAQ:AAPL), Qualcomm (NASDAQ:QCOM), Intel (NASDAQ:INTC) and Huawei. Owning Arm would have potentially given Nvidia vast amounts of pricing power. It would have been in a position to drive a tough bargain with companies like Huawei and Apple that are absolutely loaded with cash.

This sort of maneuvering could have supported the enduring growth story for Nvidia. Even as the crypto mining boom fades and the pandemic surge ends, perhaps Nvidia still had another chapter in its book by bringing Arm into its empire. Now, though, with regulators scuttling the deal, it's hard to see what Nvidia's next big milestone would be. And, in the meantime, the company's market capitalization far exceeds what you'd expect to see based on its current business results.

NVDA Stock Valuation Makes No Sense

During the dot-com boom around the year 2000, Nvidia's shares never traded for more than 15 times revenue. After that bubble collapsed, NVDA stock fell to around 1 times revenue. Up through 2015, it would trade between 1 and 6 times revenue.

Since 2016, Nvidia has enjoyed a second golden age, as traders plowed into the stock regardless of the price. NVDA stock recently topped 30 times revenue. This means that, for all the fundamental improvement at Nvidia, traders were willing to pay fives times or more as much for each dollar of sales as they used to.

Maybe the right price-to-sales ratio for Nvidia is 5, or maybe it's 10. The stock was too cheap prior to 2016. But a 30 times sales multiple is equally ridiculous to the upside as the 1 times multiple was at the trough. Traders were long Nvidia hoping its revenue could keep compounding at an unusually high rate forever. Or, in some cases, it wasn't even about fundamentals at all. Instead, traders just held the stock because it was going up and, thus, had great technical indicators.

Ultimately, however, expect Nvidia to settle down below 10x sales, which would imply that the stock gets cut in half or more from here. The great semiconductor shortage will end sooner or later. And Nvidia's profit margins will top out and start to decline, especially since it couldn't finish the Arm purchase. As crypto switches to proof-of-stake algorithms, a key demand driver will disappear, further slowing Nvidia's trajectory.

NVDA Stock Verdict

Morningstar's Abhinav Davuluri recently cut his price target for NVDA stock from $194 to $187. Davuluri saw some advantages from Nvidia owning ARM. In particular, it would have significantly reduced competiton, potentially giving Nvidia the ability to raise its profit margins dramatically.

The Arm deal was a bold move that could have greatly improved Nvidia's profit margins and supported its eye-watering valuation. Without it, Nvidia's fundamentals aren't remotely strong enough to justify the current stock price, and shares have strong downside potential ahead of them.

Davuluri sees nearly 30% downside for NVDA stock from here, but I think that's too optimistic. Based on long-term valuation metrics, Nvidia is worth even less than his $187 per-share price target.

On the date of publication, Ian Bezek held a long position in INTC and QCOM stock. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.

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