Analysing Technology Valuations and the Impact of Artificial Intelligence

Since the launch of ChatGPT, large-cap technology companies expected to benefit from AI-enhanced software tools and model training capabilities in the cloud have seen a significant rebound in their share price. However, many of these companies have yet to achieve significant AI-driven revenue growth. This has led Blake Heimann, Senior Associate, Quantitative Research at WisdomTree to question whether current levels of capital expenditure (capex) could justify a positive return on investment (ROI), given the industry’s heavy investment in hardware infrastructure. For this reason, Heimann has conducted the following analysis of technology valuations and the impact of Artificial Intelligence.

Analysis of technology valuations and the impact of AI

Investing in AI: Immediate benefits or a long-term bet?

The main beneficiaries of this investment so far have been Nvidia and other semiconductor manufacturers. These companies have experienced exponential revenue growth due to the high demand for AI training chips. However, questions remain: Will end users and enterprises see enough value to justify these costs? Will current investments in AI infrastructure be profitable? And, more importantly, do these enterprises have a fair valuation?

Against this backdrop, Heimann examines whether the current share prices of these tech giants are justified, considering the modest impact AI has had on their earnings so far.

Valuation trends and market sentiment

The narrative has always positioned AI as a software revolution. While semiconductors are essential tools, software is seen as the key differentiator, as users seek the most advanced and intelligent platforms. As a result, large-cap technology companies have seen significant share price appreciation since the launch of ChatGPT, driven by investor optimism about the potential future benefits of AI. However, this enthusiasm has led to multiple valuation expansions, which some see as a potential bubble.

Looking at the period since ChatGPT’s launch, the forward price-to-sales (P/S) ratio of the Nasdaq has risen from 3.8 to 5.0, an increase of 34%. In contrast, companies such as Amazon, Google, Meta and Nvidia have recorded increases of more than 50%, and some have even exceeded 100%. This could indicate that these stocks are either overvalued or that the market considers them fairly valued, given expectations of significant future AI revenues and earnings potential beyond current sales estimates.

Shifting sentiment on Wall Street: From optimism to caution

Wall Street sentiment towards these companies has recently shifted from positive to negative. Investors have begun to question the potential return on investment of the large sums of capital and the time required to obtain it. Recent financial reports from major technology companies have produced mixed results.

• Amazon saw its shares fall due to a subdued revenue outlook and disappointing sales, exacerbated by rising costs to expand Amazon Web Services.
• Microsoft reported slowing growth in its Azure cloud computing segment, along with plans to continue to invest substantially in data centres.
• Meta had good financial results, reassuring investors and buying time for its AI investments to start paying off.
• Alphabet (Google), on the other hand, saw its shares fall after a surprise cost increase, despite better-than-expected sales.

A weaker-than-expected employment report at the end of the week exacerbated these declines, leading investors to reassess their positions amid the economic slowdown. As a result, the previously high valuations of these stocks have begun to fall, as concerns grow that the excitement around AI is not meeting expectations.

Are we in a market bubble? Comparing to the past

Examining current P/E ratios compared to historical trends can provide valuable information on whether valuations have become overstated relative to the past. Nvidia and Microsoft, for example, stand out as outliers, with P/E ratios significantly higher than their historical averages over the past 10 years. This could suggest that the market expects fair value for solid growth in the future or it could indicate overvaluation.

By comparing to past market bubbles, such as Cisco’s during the dotcom era, we can gain valuable context. Cisco’s P/E ratio soared to 60 before the share price plummeted more than 80% in the early 2000s. Today, Nvidia’s P/E is about 35, indicating a less extreme valuation than in the dotcom bubble.

The importance of managing risk and expectations

While investing in AI and exponential technologies is exciting, it is crucial to take a valuation-sensitive approach. Rather than avoiding these investments altogether, investors should adjust their exposure as valuations fluctuate, avoiding excessive concentration on valuation peaks and maintaining a diversified portfolio.

Historical perspective suggests that while market valuations have significantly risen since the launch of ChatGPT, we are not necessarily facing a dotcom bubble in the early 2000s. However, the prudent approach would be to keep a constant watch on valuation trends to manage risk and take advantage of opportunities when valuations are at more reasonable levels.