Over the past three years, shares in Taiwan Semiconductor Manufacturing Co (TSMC) have achieved a compound annual growth rate (CAGR) of 49% in dollar terms. That sounds amazing until you look at Nvidia’s outrageous 119% CAGR over the same period. It’s clear who the overall winner in the AI boom has been, with Nvidia trading on an earnings multiple of 46 and TSMC on 26. TSMC is playing second fiddle to Nvidia, but at least it’s doing so on a more modest valuation.
There are several supply bottlenecks in the AI chain. Energy, racks, cooling systems — and, of course, silicon. TSMC has taken full advantage, with analysts estimating average selling price increases of close to 20% as customers are willing to pay up for increasingly high-performance chips from the company.
This does great things for margins. As the latest results tell us, full-year 2025 saw gross margin at TSMC widen 380 basis points (bps) to 59.9%. Momentum into the end of the year was even more encouraging, with gross margin in the fourth quarter of 62.4%. A strong capacity utilisation rate creates manufacturing efficiencies and improved overhead absorption per unit. This stuff might be cutting-edge technology, but the usual principles in manufacturing still apply: when volumes are high, margins usually follow suit.
This gross margin increase drove an improvement in the operating margin of an astonishing 510 bps, tipping the scales at 50.8%. Cost control is clearly a commitment throughout the income statement, not just in the manufacturing process. This margin expansion, combined with full-year revenue growth of 35.9% (in dollars), drove earnings per share (EPS) up 46.4%.
It all sounds fantastic, but now we get to the challenge at TSMC: the company is incredibly capex hungry. If you’re looking for a company with high free cash flow conversion rates, you’re in the wrong place. Free cash flow was up 15.2% in 2025 — respectable, but way below the growth in EPS. In an effort to keep investors happy, the dividend per share increased 28.6% as the company ramped up the cash flow payout ratio. This can only be a temporary strategy, as it is impossible for the dividend to grow at a higher rate than free cash flow indefinitely.
In an effort to keep investors happy, the dividend per share increased 28.6% as the company ramped up the cash flow payout ratio
The heavy capex requirement is driven primarily by the more advanced process technologies. Between 70% and 80% of the capex budget in 2026 will be allocated to chips that are 7nm (nanometres) and below. These chips accounted for 77% of wafer revenue in 2025, so that percentage makes sense. Digging deeper into the management commentary reveals that the mix within the 7nm-and-below bucket reflects the more demanding capex intensity (measured on a per-wafer basis) of the really high-performance products (such as 3nm technology).
As it takes time for volumes to build up, production of the most advanced technologies is initially margin-dilutive for the group. The sweet spot at the moment is 5nm wafers, with 3nm wafer gross margin running below the corporate average. As TSMC looks to ramp up the impressive 2nm technology in 2026, it expects a dilutive impact on margins.
TSMC may have multiple product lines, but the high-performance segment that serves the cloud and AI applications accounted for 55% of revenue in Q4. Next up are smartphones at 32%, with the other two major segments being the internet of things and automotive at 5% each. This capex is therefore being allocated based on expectations of AI and cloud demand, which means that TSMC is a central figure in the debate about whether we are in a cyclical or secular demand environment.
Those expectations remain high, with management noting that capex will be “significantly higher” in the next three years vs the preceding three years. Return on equity is expected to be in the high 20% range through the cycle — a cautious outlook vs the latest level of more than 35% and a reflection of the heavy investment required. The capex plan includes expanded manufacturing in Arizona, as TSMC must address the fears of US customers about Taiwan’s proximity to (and tense relationship with) China.
Management has guided a five-year revenue CAGR of 25% (measured in dollars and using 2024 as a base). It has been running at 18% over the past three years, so this is spicy guidance from a management team that is usually conservative.
If management is right, the AI trend is only just warming up. And if it is wrong, then there is going to be serious blood in the water based on all this capex investment.
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