Wall Street analysts are bullish on Broadcom and ServiceNow due to their potential in the AI market.
Broadcom is benefiting enormously from increasing investment in AI infrastructure.
ServiceNow is seeing high demand for its business automation software.
In a year of uncertainty for the economy, leading companies in artificial intelligence (AI) are standing out. Wall Street analysts recently made bullish calls on Broadcom(NASDAQ: AVGO) and ServiceNow(NYSE: NOW).
One thing that stands out at first glance with these stocks is their expensive valuations. Both stocks trade at high multiples of their earnings and cash flow that could limit near-term upside. Let's see why these stocks may or may not justify their premiums.
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1. Broadcom
Broadcom supplies essential networking and other components for data centers. It benefits enormously from the investment pouring into AI infrastructure right now. After falling to a low of $146.29 this year, the stock has rebounded sharply in recent weeks to around $200, with the average Wall Street analyst still rating the stock a buy.
As AI workloads increase in the data center, it puts more stringent requirements on advanced computing hardware, particularly the need for high-speed data transfer. Broadcom is meeting this demand. Its revenue grew 25% year over year last quarter to nearly $15 billion, with AI-related revenue surging 77% to $4.1 billion.
Broadcom also supplies AI chip solutions for data centers, which are in high demand partly due to the short supply and high costs of Nvidia's graphics processing units (GPUs). Broadcom sees AI chip revenue reaching $4.4 billion in fiscal Q2.
It's for this reason that Seaport Research analyst Jay Goldberg recently rated Broadcom shares a buy, while recommending investors sell Nvidia. However, investors shouldn't overlook the stock's high valuation. Broadcom stock trades at 97 times trailing earnings and 30 times this year's earnings estimate. Broadcom's earnings multiple is toward the high end of its previous trading range, suggesting it might be overvalued. Even for a company expected to grow earnings at an annualized rate of 20% in the next few years, Broadcom is priced at a premium.
Most analysts are still bullish on Nvidia due to its recent momentum and competitive position in the GPU market. By comparison, the consensus analyst estimate still has Nvidia's earnings growing at an annual rate of 35% in the coming years, yet its shares trade at a more reasonable 25 times forward earnings.
The chip industry is historically cyclical and can experience periods of slower demand during economic recessions. With a lot of uncertainty for the economy this year, investors should be careful before paying a higher earnings multiple for Broadcom. It could face relatively more downside risk if the chip industry's growth stalls in the near term.
2. ServiceNow
ServiceNow could be a huge beneficiary of future spending on AI-powered software that helps companies speed up workflow. The Wall Street consensus is high on its prospects and rates the stock a buy.
ServiceNow sees the addressable market for its software reaching $275 billion by 2026. Subscription revenue grew 19% year over year in the first quarter, with remaining performance obligations up 25% to $22.1 billion.
Management is seeing strong demand from companies looking to increase efficiency. It sees a growing opportunity in the federal sector, as the U.S. government seeks more cost-efficient solutions in technology. Overall, ServiceNow AI products saw a significant acceleration in demand to start the year, and management's guidance calls for 2025 revenue to increase approximately 19% over last year.
Bank of America analyst Brad Sills noted the company's solid execution and strong demand for its workflow automation platform amid uncertainty in the economy. He rates the shares a buy and recently raised the firm's price target to $1,085.
ServiceNow stock is trading at a high valuation of 59 times forward earnings. But companies that generate recurring revenue from subscriptions generally trade at higher earnings multiples. On a free-cash-flow basis, ServiceNow shares trade at a multiple of 56, which is close to the middle of its previous five-year trading range.
This leading AI software provider seems to offer a more reasonable value for long-term investors. There's still downside risk if a soft economy leads to lower software spending. But analysts expect the company's earnings to grow nearly 30% annually in the coming years.
The recurring revenue business model along with a large market opportunity for its products is likely going to provide support for ServiceNow stock in the near term and set the stage for more returns in the coming years.
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Bank of America is an advertising partner of Motley Fool Money. John Ballard has positions in Nvidia. The Motley Fool has positions in and recommends Bank of America, Nvidia, and ServiceNow. The Motley Fool recommends Broadcom. The Motley Fool has a disclosure policy.
