Here's The Real Reason Why Broadcom Stock Tumbled Last Week

Shares of Broadcom (NASDAQ: AVGO) have been soaring this year as the semiconductor company scored major AI chip wins, but investor sentiment shifted hard last week. Broadcom stock dropped by more than 11% on Friday in reaction to the company's report for the fourth quarter of fiscal 2025.

Broadcom's results and guidance were stellar. Revenue surged 28% year over year, adjusted EPS increased 37%, and the company forecasted strong sequential growth in the first quarter of fiscal 2026. Revenue and earnings exceeded analysts' expectations, and AI semiconductor revenue increased by 74%. In the first quarter, Broadcom expects AI revenue to more than double.

Broadcom recently struck a deal with OpenAI for custom AI chips, and it's a partner to Alphabet for its TPUs as the tech giant pursues a new strategy of selling its AI chips to third-party customers. Broadcom ended the quarter with an AI-related backlog of $73 billion, nearly half of the company's total backlog.

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So why did Broadcom stock sink?

One potential explanation that emerged last week for Broadcom's wipeout on Friday despite its solid results was a forecasted dip in gross margin for the first quarter. Broadcom's management noted in the earnings call that the company's gross margin would decline by around one percentage point sequentially in the first quarter, largely due to a higher mix of AI revenue. This implies that Broadcom's AI business is somewhat less lucrative than the company's other lines of business.

While the fact that Broadcom's AI business carries lower gross margins is notable, a one percentage point decline in the overall gross margin is not particularly meaningful. The more likely culprit for Broadcom's weak stock performance last week is something much simpler: A valuation that's well into the stratosphere.

Broadcom was valued at approximately $1.6 trillion as of Monday morning. Analysts expect the company to report revenue of just under $96 billion in fiscal 2026, along with adjusted earnings of approximately $10 per share. Growth is expected to be robust, thanks to booming demand for AI chips.

Based on those estimates, the stock trades for nearly 17 times forward sales and over 34 times forward adjusted earnings. Broadcom is incredible profitable, converting more than half of its revenue into adjusted net income in the fourth quarter of 2025. Broadcom's GAAP operating margin has more than doubled since 2020 to over 40%.

Investors aren't buying the AI growth story

Broadcom stock appears to be richly valued relative to sales, although the company's sky-high profit margins provide some justification. With shares tumbling, one of two things, or some combination of them, is likely true. Either investors don't believe Broadcom's AI growth will hold up, or they don't believe Broadcom's incredible profit margins are sustainable.

For the time being, Broadcom's AI revenue will continue to boom. The question is: How long will the party go on? A mega-deal with OpenAI is a major component of Broadcom's growth story, but OpenAI has made massive commitments that will require extensive fundraising and revenue growth to fulfill. With OpenAI facing intense competition, it's hard to predict how any of its deals will ultimately work out.

If predictions about an AI bubble prove accurate, demand for custom AI chips could plummet, and AI start-ups could fail en masse. Under that scenario, Broadcom's AI growth would likely unwind rapidly.

Broadcom is riding the AI wave, with its stock more than doubling since April. However, with the company's valuation reaching uncomfortable levels just as fears about an AI bubble intensify, investors are starting to pull back. While Broadcom is certainly well-positioned for the AI boom, the stock may struggle under the weight of its lofty valuation.

Timothy Green has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet. The Motley Fool recommends Broadcom. The Motley Fool has a disclosure policy.