Is Palantir Stock a Buy?

This has been a good year for Palantir (NYSE: PLTR) shareholders. The data analytics company, which offers specialized artificial intelligence (AI) platforms for the military, intelligence agencies, and large corporations, achieved phenomenal top-line growth and is finally generating a profit. And with conflicts escalating around the globe, Palantir's tools are making a difference for the U.S. and its allies.

The stock is up a whopping 115% year to date and its growth shows no signs of slowing down. Investors love the speed at which it is adding new customers, its focus on AI, and its improving profitability.

But is the stock a buy right now?

AI analytics for the Defense Department and corporations

When Palantir began operating in 2003, its plan was to provide big data analytics software to the U.S. Department of Defense and intelligence agencies, like the CIA, during the global war on terror. Competing against legacy products, the company won numerous contracts with its modern and fast-improving software tools. Its U.S. government revenue hit $278 million last quarter. Given the vastness of the U.S. defense budget, there is plenty of room for Palantir's sales to Washington to grow.

Management built upon its government wins to expand into the commercial sector with great success. There is no better marketing than saying your software is good enough for the U.S. military and the CIA, and a steady stream of corporate clients have been signing deals with Palantir. Last quarter, its total commercial revenue grew 33% year over year to $307 million.

Customer count grew 41% year over year for Palantir. This is important due to its "land and expand" business model. Once established, its customers generally spend more money on Palantir's services with each passing year. These expanding relationships should provide it with a durable revenue tailwind for many years to come.

Watch expanding profit margins

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

In just two years, Palantir has gone from a negative 40% operating margin to a 12% operating margin over the last 12 months. Last quarter, this figure expanded to 16%. Given the low variable costs of software, Palantir's business model should have a ton of operating leverage. As the business keeps maturing, investors can expect to see its operating margin climb higher.

Software companies have a ton of operating leverage. For example, Adobe has an operating margin of over 35%. If Palantir can eventually get to this level, it will be generating a boatload of profits.

But that premise doesn't in and of itself make Palantir stock a buy. Valuation always matters in investing, and investors need to be clear about what expectations have been priced into Palantir's shares after their impressive surge.

PLTR Revenue (TTM) data by YCharts.

Excessive optimism is baked into Palantir stock

Palantir stock is overvalued -- plain and simple. It carries 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 grew by 27% year over year. Assuming phenomenal business performance, Palantir's revenue could accelerate -- a task that gets progressively more difficult from higher revenue bases, that's just the nature of the math -- to 40% growth over the next five years.

That would bring its annual revenues to $13.3 billion. But again, this is based on an astounding level of growth over a five-year period, and a scenario I would be surprised to see happen. However, let's assume that Palantir can do that, and then, over the same time, could also boost its profit margins to 40% -- a higher margin than Adobe's, and an extremely optimistic prediction. That would give it annual earnings of $5.33 billion five years from now.

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

This shows just how overvalued the stock is today, and explains why investors should avoid it. Even if the business crushes it, shareholders' returns from here will likely be meager over the next five years, if not longer.

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Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Adobe and Palantir Technologies. The Motley Fool has a disclosure policy.