Palantir Technologies (NYSE: PLTR) rose to the top as one of the best artificial intelligence (AI) stocks. Its prowess in AI software applications is nearly unmatched, which is why investors are so excited.
But with all this excitement, there are also high expectations. I fear that even if the company is successful, the stock price could still fall significantly because of the rise it has already made.
Can Palantir live up to these high expectations? Or are investors in for a nasty surprise?
Palantir’s software is just beginning to gain acceptance
Palantir’s software has long integrated AI with decision-making. It began in 2003 as a company focused on providing software to the government and has since expanded into the commercial sector. Its software is designed to streamline data flows and give decision-makers the best possible information.
This program is incredibly useful, especially in high-stakes scenarios (such as those in government). And Palantir’s latest product takes it to a whole new level.
The Artificial Intelligence Platform (AIP) gives developers the tools to integrate AI into a business, whether building apps for specific purposes or using AI to drive workflows and improve productivity.
This is exactly what many companies are looking for, as AI is often used as a side tool rather than being integrated directly into workflows.
AIP has been a hit on the U.S. commercial side of the business, with revenues growing 55% in the second quarter to $159 million among those customers. Perhaps even more impressive, the number of U.S. commercial customers grew 83% from a year ago to 295.
This shows that there are relatively few adapters of Palantir’s software, but there is a reason for that: cost. If we calculate the annualized revenue and divide it by the number of customers, that equates to an annual contract value of about $2.16 million. That is a very expensive software package and it limits the potential customer base.
Still, that’s just a fraction of Palantir’s business. Total revenue in the second quarter was $678 million, up 27 percent from last year.
While Palantir is a growing software company, it still knows how to make a profit (a lesson it could teach some of its competitors). The second quarter saw record profit margins, with earnings per share totaling $0.06.
But all those great statistics come at a high price, which is why I’m not so keen on buying Palantir stock right now.
Even if the company is successful, the stock price may be in trouble
Palantir is still working to maximize profitability, so using an earnings-based valuation metric doesn’t do the company justice. (The stock trades at 86 times forward earnings.)
It’s better to predict what Palantir’s valuation might be if the company were to achieve similar margins to other mature software companies. Adobe is the industry standard for software companies and the average profit margin over the past five years has been 30%.
We need to establish a growth rate for the company. Wall Street analysts expect 24% growth in 2024 and 21% in 2025, but if we give Palantir the benefit of the doubt and say it can maintain its 27% Q2 growth rate for five years, that would mean annual revenue of $8.19 billion.
If it converts 30% of that into net income, it will generate $2.46 billion in profit. We get the price-to-earnings ratio over five years by dividing the current market cap by this hypothetical profit.
That figure works out to 27.8 times five-year earnings. What is Adobe trading at now? It’s 31.4 times five-year earnings.
Palantir must therefore far exceed Wall Street’s expectations and achieve the highest profit margins in the sector for five years. Only then will the company be valued at the same price as another company is today.
This just shows the extreme expectations that are built into the stock, and that is why I am not a buyer at these prices. There are too many shares of other companies that can be bought at a reasonable price to buy Palantir now, even if the underlying company will be successful in the same period.
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Keithen Drury has positions in Adobe. The Motley Fool has positions in and recommends Adobe and Palantir Technologies. The Motley Fool has a disclosure policy.
Can Palantir Stock Live Up to High Expectations? was originally published by The Motley Fool
