The run-up in AI stocks has attracted numerous investors into the sector. Given the anticipated potential for returns, some are even willing to pay nosebleed valuations for the top stocks in AI.
Amid that emphasis, investors may often forget the two stocks most responsible for manufacturing the hardware that makes AI possible, ASML (ASML 0.13%) and Taiwan Semiconductor (TSMC) (TSM 0.98%). Both play different but essential roles in the manufacturing process. While one could not exist without the other in their current forms, only one is more likely to deliver higher returns.
The state of the two businesses
Of the two companies, ASML appears to have the edge on which is the more foundational technology. ASML has had (at least until recently) a monopoly on extreme ultraviolet (EUV) lithography. This is the technology that makes it possible to manufacture the world’s most advanced chips.
Indeed, researchers from Japan have developed technology that makes EUV lithography simpler and more cost effective. That could bring companies such as Nikon and Canon, which serve the more competitive deep ultraviolet (DUV) lithography segments, into ASML’s market. However, until alternate products emerge, investors should assume ASML remains dominant.
It is that dominance that makes TSMC dependent on ASML to provide the equipment that allows it to make the world’s most advanced chips. TSMC takes chip designs from Nvidia, AMD, Qualcomm, and others, producing the chips for such clients.
Indeed, it has competitors such as Samsung and Intel. Also, a heavy conentration of facilities in Taiwan prompted Western governments to try to move more chip production to North America and Europe, and presumably, away from TSMC.
Nonetheless, TSMC has established a technical lead in chip production, allowing it to claim 62% of the foundry market, according to TrendForce. That factor alone probably makes it indispensible despite political pressures.
Comparing the financials
Thanks to the dominance of a part of the market involved with making semiconductors for AI, both stocks can beat the market over time. Still, the question as to which can is more likely to outperform the market may lie in the financials.
In the first three quarters of 2024, ASML reported 19.0 billion euros ($19.6 billion), a 6% yearly decline. Analysts blame slowing demand in China for the decline. That pullback trickled down to its net income, which dropped to 4.9 billion euros ($5.0 billion) in the first nine months of the year, down from 5.8 billion euros in the same year-ago period.
In contrast, TSMC remains in growth mode, with its $63 billion in revenue for the first nine months of the year up 32% yearly. Expense growth roughly stayed in line with revenue, so its comprehensive income of $26 billion for the first three quarters of 2024 surged 33% higher over the previous 12 months.
Not surprisingly, the divergent financials meant that TSMC dramatically outperformed ASML over the last year.
Despite those returns, ASML has a higher P/E ratio of 39 compared to 33 for TSMC. Nonetheless, investors should take past valuations into consideration.
ASML has had an average P/E ratio of 43 for the last five years, so it is comparatively cheap at the moment. Conversely, TSMC has averaged a 24 earnings multiple over the same timeframe, signaling it could pull back if business conditions worsen.
ASML or TSMC?
Admittedly, the valuation averages make choosing between these AI stocks a more difficult call, but I still think investors are more likely to earn higher returns from TSMC.
Indeed, the fact that TSMC needs ASML more than the other way around should bode well for ASML. Still, with the shrinking revenue, it is likely cheaper for a reason.
Indeed, paying a higher-than-average earnings multiple on TSMC makes it riskier. However, 33 times earnings multiple is relatively inexpensive for an AI stock. Moreover, the AI boom means TSMC benefits from rapid revenue and earnings growth. That factor should make paying the relative valuation premium less risky and, ultimately, lead to higher investor returns going forward.
