Can Megacap Tech Stocks Parlay the AI Craze into Higher Profits?

Seven megacap technology stocks in the S&P 500 ($SPX) (SPY) have driven about three-quarters of the S&P’s gain this year in a rally sparked in part by investor obsession with artificial intelligence (AI).  These companies, including Microsoft (MSFT), Nvidia (NVDA), Alphabet (GOOGL), Apple (AAPL), Amazon.com (AMZN), Meta Platforms (META), and Tesla (TSLA), need to deliver on the promise of AI earnings to justify their high valuations.

The rallies in these seven megacap stocks have pushed their valuations to frothy levels, with the companies’ shares trading at an average of 32 times earnings.  JMP Securities said, “We’re getting closer to the moment when the companies that are claiming AI-related profits will have to start showing them.” The seven megacap stocks delivered record profits of $99 billion in Q3, and with these companies comprising nearly 30% of the S&P 500, they have more sway over the direction of the index than ever.

This year, Nvidia has been the main driver of much of the megacap stock gains.  It is the only megacap stock that has delivered a significant jump in results due to demand for AI.  Nvidia is projected to generate about $28 billion in profit this year, up from about $4.4 billion in profit last year.  Most of the gains are from the sales of its accelerator chips used to train the large-language models that underpin AI applications like ChatGPT. 

Most of the other megacap technology stocks have yet to show any meaningful increases in revenue or sales from AI.  Microsoft, which should benefit from AI exposure due to its $13 billion investment in ChatGPT owner Open AI, earned slightly less in the fiscal year ended in June than the period before.  Analysts project Microsoft’s earnings for the next fiscal year to increase by +17%. Some analysts are optimistic about the impact of AI on future megacap earnings, with Jennison Associates confident that profits from AI will help make some megacap stocks look like bargains at current prices.

However, the markets may be too optimistic about the immediate impact of AI on megacap technology stocks, with stock prices climbing faster than earnings estimates.  The average price-to-expected earnings ratio of the group of seven megacap stocks is up from about 21 times at the start of the year, although below a July peak of 36.  Leuthold Group believes that even if the seven megacap stocks don’t fall, it’s not clear how much they can rally if valuations are already so high, saying, “We think people should be aware of the risk that those stocks have in their portfolio.”

On the date of publication, Rich Asplund did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.