Better Artificial Intelligence Stock: Nvidia vs. Arm Holdings

But it's not alone in creating massive investment returns. Arm Holdings (NASDAQ: ARM) is no slouch, either; its shares are up more than 120%. That leaves investors with an excellent dilemma: Which is the better AI stock to own?

It turns out that one is far more likely to continue its run than the other. Which one? Here is what you need to know.

Both companies play crucial roles in AI

The strong momentum behind both stocks underlines each company's key role in AI. It's unclear what that technology might look like 5 or 10 years from now, but there's a strong chance that Nvidia and Arm Holdings will be in the thick of it.

Nvidia's AI chips have become, more or less, the building blocks of AI technology. AI language models like ChatGPT train on massive data centers with thousands of chips.

Chips from Nvidia specialize in demanding, high-compute applications. These traits are perfect for AI, and the company has done a great job optimizing its chips and software for it.

Companies investing to build these AI models have all gravitated to Nvidia, giving the company an estimated 90% market share for AI chips. It's unclear when (or if) it will lose its stranglehold on the chip market.

Arm Holdings is arguably the gold standard for computer chip design. Its central processing unit (CPU) architecture is the foundation for roughly half the world's computer chips. That footprint includes smartphones, vehicles, computers, and more.

Arm makes money by charging royalties and licensing fees on each chip that uses its intellectual property. That includes Nvidia's next-generation Grace series of data center CPUs.

Both Nvidia and Arm Holdings will likely have a big say in the future of AI.

AI is already benefiting both businesses

Both companies are already seeing the impact of AI on their business. Nvidia and Arm are highly profitable, and the accelerated sales growth is lining each company's coffers:

NVDA free cash flow (percentage of quarterly revenue);

Arm's business has proved to be more profitable; the company's primary expense is research and development. Roughly $0.70 of every revenue dollar winds up as free cash flow. But Arm is a much smaller company than Nvidia. Its trailing-12-month sales are just over $3.2 billion.

Meanwhile, Nvidia isn't quite as efficient as Arm in converting sales to cash flow, but it's bringing in far more revenue: nearly $80 billion over the past year.

Nvidia's ability to sell a physical product at such high margins is impressive, and that is why it will generate far more cash flow than Arm over the long term. More cash flow gives a company more options. Nvidia even came close to buying Arm Holdings before the company went public, but the merger fell through. Give Nvidia the edge here for its comparable profitability at a much larger size.

The gap widens when talking about valuation

Analysts are equally optimistic about both companies' earnings growth over the coming years. Consensus long-term estimates call for roughly 31% annualized earnings growth for both Nvidia and Arm. However, you can see below that the starting valuation for each is dramatically different:

NVDA PE ratio (forward)

At a forward price-to-earnings (P/E) ratio that is half as expensive as Arm Holdings', Nvidia stock has a built-in margin of safety. Assuming growth estimates prove accurate, Nvidia is far more likely to perform better.

As they say, the higher they go, the further they can fall. High valuations leave less room for things to go wrong. Arm Holdings could perform exceptionally well as a business, and something -- even something external to the company, like broader market volatility -- could send shares lower.

Nvidia and Arm Holdings are blue chip technology stocks with a bright future in AI due to their exceptional competitive footing. However, given the dramatic difference in valuation, Nvidia seems like the better AI stock to buy today.

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Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.