The most popular stock in the artificial intelligence (AI) software space is undoubtedly Palantir (NYSE: PLTR). The stock is up an incredible 160% this year and dwarfs the performance of the software company that most want to be when they grow up: Adobe (NASDAQ: ADBE).
Adobe's stock is down 15% this year, but it also belongs in the AI conversation because it is heavily pursuing the AI image-generation market as well as AI video. However, despite Palantir's fantastic year and Adobe's poor one, Wall Street thinks investors would be wise to sell Palantir and buy Adobe.
Why? Well, the answer centers around valuation.
Both companies have an AI investment case
Palantir's AI platform is designed to give anyone with decision-making power the most up-to-date information possible. It involves processing multiple data streams simultaneously and then harnessing the power of AI to make recommendations. Originally, this software was designed for government use, but it has also made its way into the commercial sector.
More recently, Palantir's new product, Artificial Intelligence Platform (AIP), has gained steam. AIP allows companies to build generative AI into their business systems, which turns AI from a tool someone might use on the side to one integrated into workflows. This is a critical step, as it controls what information a large language model sees and prevents sensitive information from entering another company's database.
Adobe isn't quite as technologically advanced as Palantir. Its product suite is the industry standard for graphics design, but Adobe isn't asleep at the wheel. It has added Firefly to its product lineup, allowing creators to adjust images or create new ones with text input. However, many generative AI models already have this capability, so Firefly isn't setting it apart.
Few models can generate AI video, yet Adobe is nearing the full-scale launch of Firefly Video. With Adobe at the forefront of this fundamental change in how people work, it isn't at risk of being replaced anytime soon. However, the stock doesn't get as much respect as it used to.
Both Palantir and Adobe have legitimate investment theses and are strong AI companies. However, Wall Street is much more bullish on Adobe than Palantir, and I agree.
Palantir is priced far too high for its growth
Wall Street currently has an average price target of $27.67 on Palantir's stock, indicating about 35% downside. Adobe's one-year average target is $621.15, indicating about 25% upside (both consensus targets are from TipRanks).
Why the large discrepancy? It has to deal with valuation.
While Palantir may be growing faster than Adobe, the price you must pay for that growth is too high for many investors.
Palantir currently trades for an unbelievable 41.1 times sales. For comparison, Adobe trades for 41.6 times its earnings. That's a huge discrepancy, as investors care about earnings once a company fully matures.
To illustrate how expensive Palantir is, let's calculate how much growth it would need to reach Adobe's valuation.
In Q2, Palantir grew its revenue at a 27% pace, and management expects to grow Q3 revenue by 25%. But for argument's sake, let's say it can grow between those two projections (26%) for five years. That's probably longer sustained growth than Palantir can put up (Wall Street thinks it will grow revenue at a 21% pace in 2025), but it's what's required to get the outcome the stock is priced for.
Furthermore, let's say that Palantir can improve its profit margin from its current 20% level to Adobe's 30% level. That's a much more reasonable projection, as Palantir has steadily improved its margins over the past few quarters.
If it does both things, Palantir's stock would generate $2.36 billion in profits five years from now, giving it a 40.7 times trailing earnings valuation.
That's with zero change in today's stock price. So if you think Palantir will be a better stock to own over the next five years, Adobe's price would have to go down.
I think that's a terrible bet, as Adobe has shown a knack for consistently growing at the mid-teens pace each year.
Owning Palantir instead of Adobe doesn't make a lot of sense, as the expectations baked into the stock are outrageous. Although Palantir is a flashy AI stock, you'd be better off owning the stalwart that continues its steady, market-beating trajectory year after year.
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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.
