Is the AI Boom Turning Into a Bubble? Here's What Smart Investors Should Watch.

Most tech investors credit artificial intelligence (AI) with ending the 2022 bear market and sparking a boom in stock prices. Those gains created a new crop of transformational stocks, with companies like Nvidia (NASDAQ: NVDA) and Palantir leading the pack.

Now, the staggering gains in some of these stocks have led investors to speculate whether AI stocks are in a bubble. Knowing this, have investors missed this boom, or can they still find opportunity by investing in AI?

Here's what investors should know and watch.

Image source: Getty Images.

Understanding bubbles

In this context, investors must first understand stock market bubbles. They occur when stock prices increase considerably faster than the value those stocks represent.

Admittedly, one can find individual AI stocks that arguably sell for "bubble level" valuations. An example is Palantir, whose forward P/E ratio recently exceeded 275. Over time, its profits would likely have to increase considerably to justify such a forward earnings multiple.

Moreover, bubbles can be dangerous, even for long-term investors. One can look at Micron, whose stock did not return to its dot-com bubble high until 2022. Also, the price of silver just now achieved a new all-time high, something silver bulls have waited for since 1980.

Since few investors can afford to wait out such recoveries, it is critical for them to differentiate between bubbles and the overvaluations common with tech growth stocks.

Assessing AI valuations

Once investors better understand bubbles, they need to take stock of the industry's growth. According to Grand View Research, the AI industry is expected to grow from around $279 billion in 2024 to approximately $3.5 trillion by 2033. That amounts to a compound annual growth rate (CAGR) of 32% over the next eight years.

That indicates two things. For one, the "bubbles" in AI are less likely to pop anytime soon amid the industry tailwinds. Additionally, even beginning investors will probably have time to profit from an AI-driven bull market. Fortunately, the individual stocks show wide variances in terms of valuations.

For example, despite 1,500% gains over the last three years, market leader Nvidia has a P/E ratio of 52. While that is above the S&P 500's average of 31, it hardly represents bubble territory. It is also cheaper than rival AMD with a 139 P/E ratio. Still, when considering AMD's forward P/E of 62, its possible overvaluation does not compare to the higher valuations of stocks like Palantir.

Even among the "Magnificent Seven," stocks like Google parent Alphabet and social media giant Meta Platforms have P/E ratios below 30. Also, Qualcomm is arguably the value stock in the AI space. At a P/E of 16, it is likely investors are more concerned about muted upgrade cycles and China exposure than they are about the AI-enabled chips the company continues to release.

Instead, some of the higher valuations that could be in bubble territory seem to involve smaller stocks. Stocks like SoundHound AI, a mid-cap stock specializing in voice-enabled AI, do not even earn profits. Knowing that, its price-to-sales (P/S) ratio of 58 might concern investors given the S&P 500's average P/S ratio of 3.4.

More extreme valuations appear among quantum computing stocks. IonQ sells at a P/S ratio of 272, while Rigetti Computing's sales multiple is nearly 1,500. This could indicate that the quantum computing subsector is in a bubble, but neither of those represent AI stocks as a whole.

Is the AI boom becoming a bubble?

After evaluating individual stocks, investors should not think of AI stocks in general as a bubble.

Admittedly, one can find likely bubbles in the sector, and stocks like Palantir and some smaller stocks that specialize in quantum computing may fit that description.

Still, most stocks, including Nvidia, are likely not in bubble territory. When also seeing the low valuation of Qualcomm, investors should understand that they can find AI stocks trading at a wide variety of valuations.

That bodes well for an industry growing at an estimated 32% CAGR. With the AI growth likely to continue for years, investors should not shy away from the sector over "bubble" fears.

Will Healy has positions in Advanced Micro Devices. The Motley Fool has positions in and recommends Advanced Micro Devices, Alphabet, Meta Platforms, Nvidia, Palantir Technologies, and Qualcomm. The Motley Fool has a disclosure policy.