Congratulations to all the NVIDIA Corporation (NASDAQ:NVDA) investors and long-positioned traders. The stock is up 207% over the past twelve months, outperforming the S&P 500 (SP500) by more than 175 percentage points. With Nvidia equity trading at about 80x TTM earnings and 40x book value, market sentiment is splitting more aggressively: One camp of market participants argues that Nvidia's bull market has more room for upside (for example, see here, here, and here), while the other camp sees shares as grossly overvalued (for example, see here, here, and here).
Personally, I would position myself in the second camp. While there is certainly a fundamental component to Nvidia's eye-watering performance, I argue that a large part of the share price rally has been driven by bullish momentum in options trading and associated hedging flows.
On that note, regarding the 21st of June, we are approaching a key option expiration date that may negatively shift the Gamma momentum for Nvidia, as almost 5 million open interest in Call contracts expires. This should significantly lower the bullish hedging activity of options dealers, and thus give Nvidia shares more "freedom" to trend towards fair value. From a fundamental view, I value Nvidia stock using a residual earnings model and calculate an implied target price equal to $76.4 per share.
Fundamentals Boom, But Growth And Margins Likely To Level Out
Nvidia's latest earnings report highlighted ongoing strong demand for AI-related CAPEX spending. During the period from February to the end of May, the company accumulated $26 billion of revenues, up 18% vs. Q4 and up 262% vs. the same period one year prior, while beating consensus by 5%. EPS came in at $6.12, beating consensus by 9%. Notably, the strong performance was mainly driven in the Data Center segment, where revenue reached a record $22.6 billion, up 23% QoQ and up 427% YoY.
On a high level, the key message from Nvidia's earnings call with analysts was that demand continues to outpace supply for Hopper and Blackwell. Moreover, Nvidia suggested that the company sees accelerating demand from GenAI for both Inference and Training. Guidance for Q2 came in at about $28 billion for revenues and $6.2 - $6.8 for EPS (Not split adjusted, to keep EPS outlook comparable with Q1 reporting. Split adjusted it would be 0.62-0.68 cents; modelling anchored on non-GAAP gross margin guidance of about 75.5%, and non-GAAP operating expenses guidance of about $2.8 billion).
Nvidia's strong Q1 print undoubtedly highlights that there is a solid fundamental component attached to NVDA's record-breaking bull run. However, while the fundamentals are solid and pointing upward, the implied valuation of Nvidia shares may excessively discount the positive commercial momentum. Pointing to the cyclical nature of the semiconductor industry, paired with accelerating competitive dynamics in AI chip development, I argue that Nvidia's triple-digit YoY topline expansion rate and 60% EBIT margin may not be defendable over time. For example, equity research analysts at BNP Paribas have broken down Nvidia's growth outlook by segment and concluded that Nvidia's topline growth will likely slow to 20-25% YoY by the end of FY 2025 (Source: BNP Paribas, research note on NVDA dated 23 May 2024).
The Importance Of Gamma...
Positive Gamma is crucial for upside momentum in the market because it influences how options market makers adjust their hedging strategies, which can amplify price movements. On a more detailed level, Gamma measures the rate of change of delta, which is the sensitivity of an option's price to changes in the underlying asset's price. When traders or market makers sell options, they often hedge their positions by buying or selling the underlying asset to stay delta-neutral, meaning they aren't exposed to price changes in the underlying asset. In that context, positive Gamma means that as the underlying asset's price increases, the delta of the options also increases, requiring more buying of the underlying asset to maintain a neutral position.
This self-reinforcing mechanism can contribute to strong upward momentum. In scenarios where there is significant call option buying like it has certainly been the case with NVDA stock, there is a build-up of positive Gamma, which can lead to sharp rallies for the reasons explained.
...And What It May Imply For Nvidia Stock
The strong commercial momentum for Nvidia's products has driven speculative call-buying for NVDA stock. On that note, I highlight that Call open interest for Nvidia with expiration dated 21 June almost reaches 5 million contracts, or 500 million of underlying shares (notional worth close to $65 billion!), with most of the strikes centered in the range of $120-$140. Across expiration dates, the cumulative open Call interest is about 13-14 million contracts or $175 billion worth of notional.
The enormous open interest for Nvidia shares has resulted in an equally enormous net positive Gamma exposure, with most of the Gamma anchored to the 21st June expiration date.
Bringing the Gamma exposure into context, I highlight that a 1% move in Nvidia shares would result in $2.5-3.0 billion of buying activity to hedge the options' Delta. With Nvidia shares moving up and down during the day, the hedging activity likely accounts for 25-30% of trading volume, according to my rough estimates.
Now, the interesting takeaway for readers relates to the previously highlighted observation that about 5 million NVDA options contracts are expiring on June 21st. Once these options expire, the associated hedging flow will also stop to support NVDA shares with buying pressure. Moreover, investors should note that when market participants buy call options, market makers who sell these options often hedge their positions by buying the underlying stock to remain delta-neutral. As the expiration date approaches, market makers may start unwinding their hedges, which involves selling the stock they previously bought. This could lead to notable downward pressure on the share price.
Valuation: Fair Value Likely At $76.4 Per Share
To find a valuation anchor for stocks, I am a great fan of using the residual earnings model approach. This model is based on the principle that a company's valuation should equal its discounted future earnings after accounting for the capital charge. According to the CFA Institute:
Conceptually, residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company's capital.
For my valuation model of Nvidia stock, I make the following assumptions:
EPS Forecast: I use the consensus analyst forecast from the Bloomberg Terminal through 2027. Beyond 2027, I consider estimates too speculative to be reliable. However, the 2-3 year analyst consensus is typically accurate.
Capital Charge: I use the CAPM model to estimate Nvidia's cost of equity, which suggests a rate of 9.7%.
Terminal Growth Rate: I apply a terminal growth rate of 4% post-2027, which, I believe, is reasonable (around 1.5-2.0 percentage points above nominal GDP growth to reflect structural growth in the digital economy).
Investors with different assumptions about Nvidia's cost of capital and terminal growth rate can refer to the enclosed sensitivity table.
Based on these assumptions, I calculate a base-case target price for Nvidia of approximately $76.4 per share.
My base-case projection for Nvidia's target price suggests a potential downside. However, it is crucial for investors to consider the risk and reward ratio of investing in a company from a "scenario" perspective. To evaluate different scenarios based on various assumptions, I have created a sensitivity table analyzing Nvidia's cost of equity and terminal growth rate. See below.
Investor Takeaway
Nvidia investors have scored a big win. The stock is up more than 200% over the past twelve months, outperforming the S&P 500 by almost 10x. Although Nvidia's exceptional performance has some fundamental backing, I believe a substantial portion of the price rally is due to bullish momentum in trading and speculation.
One key consideration in this context is options trading and associated hedging flows. Over the past few months, bulk buying of call options forced option dealers to hedge their position by purchasing the stock, thus creating a feedback loop of rising prices. However, the "Gamma-squeeze" may come to an end on June 21, as nearly 5 million open interest in call contracts will expire. This could notably pressure bullish trading momentum and may result in price pressure as options dealer start unwinding their hedges.
On a fundamental view, using a residual earnings model, I see Nvidia shares as overvalued -- calculating an implied target price of $76.4 per share.
A Note On Risk
The Gamma dynamic has certainly been a major force in driving Nvidia Corporation shares higher. However, investors should note that other factors to consider are important too. On that note, Nvidia's valuation may continue to challenge skeptics, driven by strong underlying fundamentals and sustained demand for AI-related technologies. In fact, as long as Nvidia's revenue growth rate and profit margins remain robust, investors may continue to like Nvidia stock at current prices, buying the flow coming to market from option dealers' books, and the stock may defy expectations of a correction.
Cavenagh Research
Experience as an investment analyst for a major BB-Bank, as well as private equity consultant for MBB. Currently working towards the CFA charter, having completed I&II. Passion for risk-assets (Growth, Contrarian, Emerging Market) ex-colleague and close friend of Investor Express
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Not financial advice
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
