Can Palantir stock live up to lofty expectations?

Palantir Technologies (NYSE: PLTR) has made it to the top as one of the top artificial intelligence (AI) stocks. Its performance in AI software application is almost unmatched, which is why investors are so excited.

However, along with that excitement has come inflated expectations, and I’m worried that even if the business succeeds, the stock could fall prey to the upside it’s already experienced.

Can Palantir live up to these high expectations? Or are investors in for a rude awakening?

Palantir’s software is just beginning to gain adoption

Palantir software has been integrating AI with decision-making for a long time. It started in 2003 as a company focused on providing software to the government and has since expanded into the commercial sector. Its software was developed to streamline data flows and provide decision makers with the best possible information.

This program is incredibly useful, especially in high-stakes scenarios (such as those found in government). And Palantir’s latest product takes this to a whole new level.

Its Artificial Intelligence Platform (AIP) gives developers the tools to integrate AI into a business, whether it’s in applications for specific purposes or using AI to drive workflows and improve productivity.

This is exactly what many companies are looking for, as AI is mostly used as a secondary tool rather than directly integrated into workflows.

AIP was a hit on the US commercial side of the business, driving second-quarter revenue growth of 55% to $159 million among these customers. Perhaps even more impressive was the fact that the number of commercial customers in the US was up 83% from a year ago to 295.

This shows that there have been relatively few adapters of Palantir’s software, but there’s a reason for that: its cost. If we annualize the revenue and divide it by the number of customers, that gives an annual contract value of about $2.16 million. This is a very expensive software package and limits the potential clientele.

However, this is only a fraction of Palantir’s business. Its total revenue in the second quarter was $678 million, up 27% from last year.

Although Palantir is a growing software company, it still knows how to turn a profit (a lesson it can teach some of its peers). The second quarter saw record profit margins, with earnings per share totaling $0.06.

But all of these great values ​​come at a high price, which is why I’m not eager to buy Palantir stock right now.

Even if the business succeeds, the stock could struggle

Palantir is still working toward peak profitability, so using an earnings-based metric doesn’t do it justice. (The stock trades at 86 times forward earnings.)

The story continues

Instead, it’s better to project what Palantir’s valuation might be if it achieved margins similar to those of 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 business growth rate. Wall Street analysts expect growth of 24% in 2024 and 21% in 2025, but if we give Palantir the benefit of the doubt and say it can maintain its 27% second-quarter growth rate for five years, that would give it annual revenue of $8.19 billion.

If it turns 30% of that into net income, it would generate $2.46 billion in profits. We get the five-year forward price-to-earnings ratio by dividing the current market capitalization by this hypothetical return.

That figure is 27.8 times five-year forward earnings. What is Adobe marketing now? That’s 31.4 times forward earnings.

So Palantir needs to far exceed Wall Street’s expectations and achieve industry-leading profit margins for five years, and only then will it be valued at the same price that another company is right now.

This just shows the extreme expectations built into the stock, which is why I’m not a buyer at these prices. There are too many shares of other companies that can be bought at a reasonable price to justify buying Palantir right now, even if the underlying business succeeds over the same period of time.

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Keithen Drury holds 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 lofty expectations? was originally published by The Motley Fool