This AI Stock Is a No-Brainer for Investors Focused on Real Profits

Key Points

• On its face, TSMC seems a perfect AI value stock at 21x earnings and a 21% growth rate -- with a 1.8% dividend.

• TSMC generates substantially less free cash flow than its earnings suggest.

• Compare that to Nvidia, where 94% of reported net income is backed up by cold, hard free cash flow.

• 10 stocks we like better than Nvidia ›

I was recently asked to suggest a "no-brainer" artificial intelligence stock for investors focused on "real profits." And by real profits, I mean actual free cash flow that remains after deducting a company's capital expenditures from its operating cash flow -- not mere GAAP profits, or even squishier pro forma non-GAAP (adjusted) earnings.

I admit: My first thought was to recommend Taiwan Semiconductor Manufacturing Company (NYSE: TSM), the Taiwanese chipmaking powerhouse that does most of Nvidia's (NASDAQ: NVDA) contract chip work. But the more I look at the two stocks, the more I think Nvidia stock itself might be the smarter play on AI.

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A few words in favor of TSMC

Why do I think this? Ultimately, it comes down to the numbers. Let's start with Taiwan Semiconductor -- TSMC -- and why it looks so very attractive on the surface.

As the world's biggest contract chipmaker by revenue, TSMC did $111.7 billion in revenue over the last 12 months. TSMC earned $47.5 billion in net profit on this revenue, an astounding 42.5% net profit margin. And according to analysts polled by S&P Global Market Intelligence, TSMC is likely to keep on growing these profits at nearly 21% annually over the next five years.

All of the above can be acquired by any shareholder for the low, low price of just 21 times trailing earnings -- arguably even cheaper than that if you back out the $53.2 billion in net cash on TSMC's balance sheet.

Throw in a modest 1.8% dividend yield, and I'd argue that in TSMC you have not only a decent growth-at-a-reasonable price (or GARP) stock, but a not half-bad dividend stock to boot.

Why not just buy TSMC stock?

And yet, if there's one reservation I have about TSMC, one reason I hesitate to buy into Taiwan's greatest success story even now, it's the fact that maintaining the company's lead over all rivals internationally comes at a high cost in the form of continuous capital spending to build and modernize TSMC's chipmaking factories.

Over the last 12 months, TSMC spent nearly $41 billion on capex, more than twice what it spent five years ago. Subtracting capex from operating cash flow, it turns out TSMC's actual free cash flow over the past year was not $47.5 billion, but in fact only $32.1 billion.

In other words, for every $1 in "profit" TSMC claims to have earned, it actually generated just $0.675 in real cash profit.

Why Nvidia is a better investment than TSMC

Now let's compare TSMC to Nvidia, which is TSMC's second-biggest customer (after Apple), accounting for 10% of TSMC's annual revenue.

Valued in excess of $4.3 trillion, Nvidia earned $76.8 billion over the last 12 months, giving it a P/E ratio of 56.5. That's nearly 3x the P/E of TSMC, which seems awfully expensive for a stock that is supposed to grow earnings at "only" 30% annually over the next five years. At first glance, this suggests TSMC is both the cheaper and the smarter AI investment.

And yet, Nvidia finds it advantageous to use TSMC to build its chips precisely because TSMC bears the burden of making all the capital investment needed to accommodate Nvidia's business -- relieving Nvidia of this capital cost. As a result, much more of Nvidia's reported net income actually translates into real free cash flow -- which you will recall is the "real profits" sought in an AI company.

According to S&P Global data, Nvidia generated $72.1 billion in free cash flow. That's still less than the company's $76.8 billion in reported net income -- but only about 6% less. In other words, for every $1 in profit Nvidia earns, it backs up those earnings with nearly $0.94 in real free cash flow.

Why Nvidia is a no-brainer AI stock to buy

Valued on free cash flow, Nvidia stock sells for nearly a 60x multiple. At a 30% growth rate, this prices Nvidia stock at the upper range of what most tech investors agree is fair value for the best growth stocks -- an EV/FCF/growth ratio of 2.0.

Nvidia is not a cheap stock. But if your goal is to own one of the best companies in the AI space, and you're willing to pay the premium required for this, Nvidia is a no-brainer AI stock that everyone should want to own.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple, Nvidia, and Taiwan Semiconductor Manufacturing. The Motley Fool has a disclosure policy.