Palantir (NYSE: PLTR) gained traction as one of the most popular AI stocks for investors looking for software companies. It has been in this industry for far longer than many of its competitors, which gives it an edge.
However, the stock's popularity and consistent buying caused its valuation to swell to a point where future returns are already accounted for in the stock price, which may cause anyone buying now to not see any return on their investment for some time (if ever).
Demand for Palantir's products has been "unprecedented"
Palantir's software can easily be described as data in, insights out. Now, there's a lot more to Palantir's software than just that, but that guiding principle is how Palantir's software is developed. Its AI software was originally intended for government use, but then expanded into the commercial segment.
Palantir's latest product has been a major growth catalyst, especially in the U.S. commercial market. Artificial Intelligence Platform (AIP) allows its customers to integrate large language models (LLMs) into a business to help guide decision-making and use internal data. This is critical, as many businesses don't want their internal data getting plugged into an LLM owned by another company, because they lose control over what happens to the data.
AIP can also integrate generative AI into workflows, which is a critical innovation. Most generative AI tools are used on the side to boost productivity, but when they are directly integrated into business systems, they unlock far more potential.
According to management, demand for AIP has been "unprecedented" compared to other products the company has launched.
This has shown up in its results, as revenue rose 27% year over year in Q2 to $678 million. U.S. commercial revenue increased 55% to $159 million. While this shows strength in this market, it also indicates that there is huge room for expansion as it only has 295 U.S. commercial customers.
However, the problem with the market's assessment of Palantir's stock is that the market opportunity isn't as large as some investors think.
Palantir's stock is incredibly pricey
If you annualize Palantir's U.S. commercial customer revenue (multiply its Q2 metrics by four) and divide that figure by the customer count, you get the average revenue per customer. That figure comes out to $2.15 million per customer, which shows this product's cost. This severely limits the potential client base Palantir can cater to, so the market opportunity is reduced to only the largest businesses in the country.
Furthermore, Palantir isn't without competition. Each major cloud computing provider has a similar product that competes with Palantir, but these applications need to be built by developers, whereas Palantir does a lot of that work for clients. So, it's a question of whether companies want to do this themselves or they want to buy an all-in-one solution from Palantir.
This battle will go on for the next decade, and neither solution will likely be an outright winner.
However, Palantir is trading like it will be.
Right now, Palantir's stock trades for a jaw-dropping 40 times sales, nearly the same level it was at when the software-as-a-service (SaaS) bubble burst in 2022.
PLTR PS Ratio Chart
That's a very high level and one that conveys sky-high expectations.
To give you an idea of these expectations, I'll compare Palantir to two companies: Nvidia and Adobe. Nvidia is an obvious choice since it's at the forefront of the AI investment trend. Adobe is widely considered one of the top software companies, so it makes for an obvious comparison.
If Palantir can achieve Adobe-like profit margins of 30% (Palantir's current levels are 20%), it will be a successful software business. Right now, Adobe and Nvidia trade for forward earnings 27 and 48 times, respectively.
Palantir's compound annual growth rate (CAGR) for revenue (with a 30% profit margin) over the next five years must be 21.4% to reach the same valuation as Nvidia or 36.2% to reach Adobe's valuation. While the growth rate required to achieve the Nvidia valuation may seem reasonable, it's also unrealistic because Nvidia is essentially doubling its revenue at a year-over-year pace.
The Adobe projection is more realistic, and Palantir's projected revenue growth rate in 2024 and 2025, at 24% and 21%, respectively, falls far short of expectations priced into the stock.
Regardless, even if Palantir could have a valuation like Nvidia's after five years of 21% revenue growth, it would only achieve that valuation if two things happened:
The stock price doesn't move from today's price.
Palantir doesn't issue any new shares (Palantir's share count rose 3% this past year).
Both of those are poor assumptions, increasing the required growth rate for Palantir's stock to achieve a valuation level similar to Adobe or Nvidia.
Palantir is a great company, but the stock has gotten far ahead of itself. As a result, I think investors should avoid it and use some of their gains to invest in other areas of the market.
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Keithen Drury has positions in Adobe. The Motley Fool has positions in and recommends Adobe, Nvidia, and Palantir Technologies. The Motley Fool has a disclosure policy.
