Is Palantir stock a buy?

This has been a good year for Palantir (PLTR 0.98%) shareholders. The data analytics company, which provides specialized artificial intelligence (AI) platforms for the military, intelligence agencies and large corporations, has achieved phenomenal growth and is finally turning a profit. And with escalating conflicts around the globe, Palantir’s tools are making a difference for the US and its allies.

The stock is up 115% year-to-date, and its growth shows no signs of slowing down. Investors love the speed with which it adds new customers, its focus on AI and its improved profitability.

But is the stock a buy right now?

AI analytics for the Department of Defense and corporations

When Palantir began operations in 2003, its plan was to provide big data analytics software to the US Department of Defense and intelligence agencies such as the CIA during the global war on terror. Competing with legacy products, the company has won numerous contracts with its modern and rapidly improving software tools. US government revenue reached $278 million in the last quarter. Given the size of the US defense budget, there is plenty of room for Palantir’s sales to Washington to grow.

The management built on its government wins to expand into the commercial sector with great success. There’s no better marketing than saying your software is good enough for the US military and the CIA, and a steady stream of corporate clients have signed contracts with Palantir. Last quarter, its total trading revenue rose 33% year over year to $307 million.

Client numbers are up 41% year-over-year for Palantir. This is important because of its “Field and Expand” business model. Once established, its customers generally spend more money on Palantir services with each passing year. These expanding relationships should provide him with a sustainable income tailwind for many years to come.

Watch your profit margins expand

A big concern investors had about Palantir when it went public a few years ago was profitability. The company posted strong revenue growth, but its bottom line was deep in the red.

In just two years, Palantir went from a negative 40% operating margin to a 12% operating margin in the last 12 months. In the last quarter, this figure rose to 16%. Given the software’s low variable costs, Palantir’s business model should have plenty of operating leverage. As the business continues to mature, investors can expect to see operating margin increase.

Software companies have a lot of operating leverage. For example, Adobe has an operating margin of over 35%. If Palantir can eventually reach that level, it will generate a lot of profits.

But that premise alone doesn’t make Palantir stock a buy. Valuation always matters in investing, and investors need to be clear about what expectations Palantir stock has been valued at after its impressive run.

PLTR Revenue (TTM) data by YCharts.

Excessive optimism is ripe in Palantir stock

Palantir stock is overvalued — plain and simple. It has a market cap of $82 billion, which is absurd when weighed against its financial fundamentals.

The company’s trailing 12-month revenue was $2.48 billion. Last quarter, it was up 27% year over year. Assuming phenomenal business performance, Palantir’s revenue could accelerate — a task that becomes increasingly difficult from larger revenue bases, that’s just the nature of math — to 40% growth over the next five years.

That would bring its annual revenue to $13.3 billion. But again, this is based on an amazing level of growth over a five-year period and a scenario that I would be surprised to see. However, let’s assume that Palantir can do that and then, at the same time, increase its profit margins to 40% — a bigger margin than Adobe’s, and a wildly optimistic prediction. That would give it annual earnings of $5.33 billion over five years.

If its market cap were to remain constant at $82 billion throughout this time, in this unlikely scenario, Palantir would have a price-to-earnings (P/E) ratio of 15.3 five years from now. So, assuming a huge acceleration in revenue growth and Herculean operating leverage, the business would grow to an earnings ratio that was barely cheap relative to the stock market’s long-term average earnings ratio.

This shows how overvalued the stock is today and explains why investors should avoid it. Even if the business crushes it, shareholder returns here are likely to be poor for the next five years, if not longer.