Palantir Joins the S&P 500: Should You Buy the Stock?

It was a good year for investors Palantir Technologies (PLTR 1.26%). The defense contractor that focuses on software and artificial intelligence (AI) is up more than 100% year-to-date and now has a market cap of $80 billion.

Revenues are accelerating and the company is starting to generate positive earnings and free cash flow. Investors are becoming bullish on the company’s effort to acquire commercial customers who adopt its intelligence software solutions.

And it was recently announced that Palantir will be joining S&P 500 index later this month. Investors, buoyed by the news, sent the stock up more than 10 percent. Should you buy the stock based on its future inclusion in the index? The answer might surprise you.

Let’s investigate if Palantir is part of your portfolio today.

Index-inclusion mania

Over the past few years, a narrative has formed around index inclusion and stock performance. Many investors believe that — for reasons such as forced buying by index-focused funds — a stock is worth more because it’s included in the S&P 500. That’s why Palantir shares are near all-time highs right now.

To be clear: this is pure nonsense and should only be regarded as speculation. A stock is worth what the underlying business generates in cash flow that is distributed to shareholders (discounted to today).

Does this have anything to do with the index the stock is listed on? No, of course not. With Palantir, we have an example of a mimetic narrative taking hold: people believe a stock will go up because others tell them that the inclusion of indices matters, and thus will cause the stock to go up. This is faulty reasoning nothing dealing with the financial fundamentals of the business.

Adding to an index could send shares soaring — as it did with Palantir. But it doesn’t tell you anything about the value of a stock.

PLTR Revenue Data (TTM) by YCharts; TTM = last 12 months.

A thriving business

So how is Palantir’s business doing? Pretty good. Total revenue rose 27 percent year-over-year to $678 million last quarter, with U.S. commercial revenue up 55 percent.

The total number of customers has reached 593 and is growing every quarter. Once Palantir lands a customer and begins implementing its AI software and tools, it generally continues to grow revenue with that customer. So, as the number of customers continues to grow, the revenue should also continue to grow.

Even better, Palantir is growing its earnings and cash flow at the same time. Operating income was $292 million over the past 12 months, compared to massive losses when it went public a few years ago. The operating margin has now expanded to 12%. Free cash flow is also healthy at $696 million, although the company spends heavily on stock-based compensation.

Overall, the business is thriving and has a long growth trajectory, especially if you believe the tailwind of AI deployment for commercial customers.

Stock is expensive

Today, Palantir has a market capitalization of $80 billion. Its shares outstanding continue to rise, which will be a headwind to returns. In the last 12 months, the company generated revenue of $2.48 billion. That’s a price-to-sales (P/S) ratio of 34. Not an earnings multiple, but a sales multiple.

Let’s make some estimates to show why this P/S multiple is so extreme. If Palantir accelerates revenue growth to 30% annually over the next five years, it will reach $9.2 billion in sales five years from now. These are extremely aggressive growth assumptions and would make Palantir one of the largest software businesses in the world.

If the company achieves a best-in-class operating margin of 30% in five years, that’s about $3 billion in annual earnings against a current market cap of $80 billion. Or a price-to-earnings (P/E) ratio of 26.6.

The AP/E of 26.6 is close to the S&P 500 average. Remember: this comes after five consecutive years of 30% annual revenue growth and profit margins that have expanded to 30% (a rare feat ). And it doesn’t include the stock dilution that will occur due to Palantir’s stock-heavy compensation packages.

Again, a stock is worth what the company will generate in cash and redistribute to shareholders. Palantir is valued as having double-digit revenue growth over the decade and hitting its best profit margins soon. These are high expectations that will have to be OVER for the stock to do well in the long run.

No matter how good the business is, these are far too high expectations. Avoid buying Palantir Technologies stock after the 100% rally in 2024.