Nvidia is one of the hottest artificial intelligence (AI) stocks on the market, but investors should diversify their portfolios.
Hedge fund billionaire Dan Loeb compared artificial intelligence (AI) to the industrial revolution in a letter to clients written last year. The industrial revolution was a characterized by a dramatic increase in economic output as machines replaced human workers. AI promises a similar step-function increase in productivity across virtually every industry.
Loeb wrote, “We have watched AI evolve and believe the technology has matured to the point that it is driving a transformational technology platform shift similar to those seen roughly once per decade: the personal computer in the 1980s, internet in the 1990s, mobile in the 2000s, and cloud in the 2010s.”
That puts investors in front of a big opportunity. The most prudent way to benefit is to own a basket of AI stocks. Many investors will naturally gravitate toward Nvidia (NVDA 2.45%), the company whose chips power the most advanced AI systems. But ServiceNow (NOW 3.43%) is a more compelling AI stock at its current price.
Nvidia is a wonderful company, but the stock looks expensive
Nvidia’s graphics processing units (GPUs) are the gold standard in accelerating complex data center workloads like artificial intelligence (AI). The company consistently achieves record-breaking results at the MLPerfs, objective benchmarks that measure the performance of AI hardware and software. Additionally, The Wall Street Journal reports that “Nvidia’s chips underpin all of the most advanced AI systems, giving the company a market share estimated at more than 80%.”
Nvidia delivered an astounding financial performance in the fourth quarter. Revenue soared 265% to $22.1 billion on triple-digit sales growth in the data center, driven by strong demand for AI solutions. Meanwhile, non-GAAP (generally accepted accounting principles) net income jumped 486% to $5.16 per diluted share as gross margin expanded over 10 percentage points, driven by pricing power and a scaling software business.
Going forward, Grand View Research estimates that AI spending will increase at 37% annually through 2030. Nvidia will undoubtedly benefit from that tailwind. Indeed, Wall Street expects the company to grow sales at 27% annually over the next five years. But that consensus estimate makes its current valuation of 36.6 times sales look expensive.
To be clear, I am not recommending that investors sell Nvidia. It is a wonderful company with a history of cutting-edge innovation and excellent future growth prospects. But I am skeptical about its ability to deliver market-beating returns for shareholders from its current price. So investors should consider other AI stocks (like ServiceNow) at the present time.
ServiceNow is a leader in workflow digitization and automation
ServiceNow helps businesses digitize and automate workflows across departments. Its platform addresses four primary use cases:
- Technology workflows like IT service and IT operations management
- Customer workflows like field service and customer service management
- Employee workflows like human resources
- Creator workflows like software development and process automation
ServiceNow is best known as a leader in IT service management, but consultancy Gartner has also recognized its leadership in IT operations management and artificial intelligence (AI) for IT operations. Similarly, Forrester Research sees the company as a leader in low-code application development, customer service solutions, digital process automation, and risk management platforms. Those commendations tell investors ServiceNow is doing something right, but they also cue potential customers in to compelling products.
ServiceNow printed strong financial results in the fourth quarter. Total revenue rose 26% to $2.4 billion, marking the fourth straight quarter in which growth accelerated sequentially. That trend may continue in the future because remaining performance obligation (RPO), which measures momentum in the sales pipeline, actually increased more quickly than revenue. Specifically, RPO rose 29% to $18 billion in the fourth quarter.
Meanwhile, non-GAAP operating margin expanded about 150 basis points, and adjusted net income climbed 36% to $3.11 per diluted share. That reflects disciplined expense management. ServiceNow also achieved a renewal rate of 99% in the fourth quarter, up from 98% in the prior year, implying a high degree of customer satisfaction.
ServiceNow has tailwinds in digital transformation and artificial intelligence
Going forward, digital transformation (DX) should be a significant tailwind for ServiceNow. International Data Corp. estimates that DX spending will compound at 16% annually through 2027 as businesses digitize all manner of processes to improve efficiency. ServiceNow is ideally positioned to benefit from that secular trend, given its leadership in numerous relevant markets.
Additionally, generative AI should also be a significant tailwind. ServiceNow became one of the first software companies to make generative AI available to its customers when it introduced Now Assist last September. Now Assist is a suite of tools that can automate tasks and improve productivity across IT service, customer service, human resources, and development teams. Bloomberg Intelligence estimates that generative AI software revenue will increase at 58% annually through 2032.
ServiceNow CEO Bill McDermott commented on those tailwinds during the most recent earnings call:
What we have here is a strong, durable market being supercharged by a once-in-a-generation secular trend. ServiceNow has been investing, innovating, and preparing for this wave for years, which is why we’re catching it so early. Artificial intelligence is injecting new fuel into our already high-performing growth engine.
With that in mind, Wall Street expects ServiceNow to grow sales at 20% annually over the next five years. In that context, its current valuation of 17.4 times sales is tolerable. Investors with a five-year time horizon should feel comfortable buying a small position in this growth stock today.
