Huge News for Investors In This Artificial Intelligence (AI) Stock

It's TSMC's world; the rest of us are just living in it. 2024 is turning into a positive year for Taiwan Semiconductor Manufacturing (NYSE: TSM), the leading manufacturer of advanced semiconductors around the world.

The company has embarked on a big expansion outside of its home market of Taiwan due to geopolitical concerns with China, leading it to invest billions in factories in Arizona. Last week, the company announced a major milestone with these new United States factories.

Here's why TSMC's latest update is important for the business moving forward and what it could mean for the stock over the long term.

Chip yields and why they matter

TSMC's factory in Arizona is getting prepped for commercial production in 2025. As it ramps up the facility, the company tests the yield of the semiconductor wafers pumped out by its manufacturing process. These wafers then become advanced computer chips, making them vital to companies like Apple or Nvidia and the artificial intelligence (AI) revolution. The higher the yield, the more of each wafer that works in the manufacturing process. Essentially, it is a measure of how much of each wafer is working correctly.

Last week, TSMC reported that it achieved 4% higher yields at its Arizona facility compared to its factories in Taiwan. This is huge news for the company. Why? Investors and analysts doubted that TSMC's factories would be as successful outside of Taiwan, which has been the beating heart of the semiconductor market for ages. Manufacturing advanced semiconductors is no easy feat, requiring teams of scientists, engineers, advanced technologies, and institutional know-how that have been built up over decades.

Now, TSMC has alleviated fears this process could not be replicated in the United States. Higher yields mean TSMC can sell more semiconductors per unit of production while costs stay the same. In other words, it should lead to higher profits, all else being equal. If TSMC was unable to replicate its Taiwan yields in Arizona, there was a risk its profit margins would come down significantly as all these new facilities started coming online. These fears are now being put to bed.

AI demand is not slowing down

These Arizona facilities -- along with others in Japan and Europe -- will be important for the AI market over the next five to 10 years. TSMC is perhaps the only company currently capable of building the most advanced semiconductors in the world for companies like Nvidia, which is the key supplier for all the data center spending associated with the AI boom.

In simpler terms, as AI spending grows, so does TSMC's revenue. All these new factories should help the company keep up with customer demand, which looks insatiable. For example, last quarter, TSMC's high-performance compute (HPC) segment grew 11% quarter on quarter and now makes up 51% of overall sales. Just two years ago, in the same quarter, the HPC segment was just 39% of overall sales. HPC is spending on advanced semiconductors for data centers, meaning AI.

Investors should be tracking the HPC segment closely, as it is now the majority of TSMC's consolidated revenue and is growing like wildfire. If spending for data centers and AI keeps booming, TSMC's revenue will likely keep growing at a fast clip. With wafer yields close to the same levels as in Taiwan, profit margins should stay high as well. Last quarter, the operating margin was a robust 47.5%, which shows how valuable TSMC's advanced computing products have become.

ASML PE Ratio data by YCharts

A rising earnings ratio means high expectations

With these booming sales and profits, TSMC's stock has begun to soar. In the last year alone, shares are up over 100% and briefly traded at a market cap of over $1 trillion.

These gains have brought the stock's price-to-earnings ratio (P/E) to 31, which is a premium valuation and slightly higher than the S&P 500 index average. Some investors would turn away from TSMC stock due to its high P/E. However, I think this is missing the forest through the trees. Yes, TSMC has a high P/E, but it has proven over the long term it can grow earnings at a fast clip and has a big tailwind at its back in the form of AI spending. In the last 10 years, the company's earnings per share (EPS) have grown cumulatively by close to 300%.

Despite this high valuation, I think TSMC stock is a buy at these prices if you are a long-term believer in AI. One of the best businesses in the world keeps expanding its lead and is now showing it can replicate its manufacturing process in other geographies.

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Brett Schafer 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.