Wall Street Warns Investors About Palantir Stock

Source The Motley Fool

There have been few better stocks to own over the past three months than Palantir (NYSE: PLTR). The stock more than doubled in that time, far outperforming both indexes and other market leaders. This performance can be traced to several events, notably Palantir's inclusion in the S&P 500 in September and its blowout Q3 earnings.

But the biggest reason why Palantir is soaring is that many artificial intelligence (AI) investors are flocking to what they see as the software version of Nvidia, which was the leader on the hardware side of AI investing. However, Wall Street analysts aren't as keen on the stock as other investors, as the current one-year average price target from 22 analysts is $36.70, according to the Wall Street Journal.

That represents a nearly 40% decline from today's prices, so there is clearly a disconnect between what analysts think and how the market is pricing the stock. Is this a warning sign that investors should heed? Or are the analysts wrong?

Palantir's U.S. growth pushed the stock higher

Palantir made a name for itself by offering purpose-built AI models for its clients. While it started off by doing this in the government sector, it eventually expanded to the commercial side. As of Q3, government revenue is still larger than commercial revenue, with government revenue making up 56% of its total.

Palantir is a global business, and its software has been deployed worldwide by governments and businesses alike. However, the bulk of its growth is coming from U.S. sources.

Sector U.S. Growth Total Growth U.S. Revenue Share
Commercial 54% 27% 57%
Government 40% 33% 78%

Data source: Palantir.

These are impressive growth figures, and they give bullish investors some confidence that U.S. momentum could carry overseas and boost revenue growth globally.

Additionally, Palantir is growing responsibly rather than following a growth-at-all-costs strategy. The third quarter represented another quarter of a steady profit margin, which is a fantastic sign that Palantir's management has also placed a strong emphasis on profitability.

PLTR Profit Margin (Quarterly) Chart

PLTR Profit Margin (Quarterly) data by YCharts

However, as good as these results may be, the biggest question is whether the fundamentals of Palantir's business can actually match the expectations built into the stock price, as many investors and analysts (like myself) don't think they can.

The stock has unreal expectations baked into it

The problem with comparing Palantir to Nvidia is that Palantir isn't putting up Nvidia-like growth. While 30% year-over-year revenue growth companywide is fantastic, it's nowhere near what Nvidia delivered investors when it tripled its revenue for multiple quarters.

I doubt it ever will, as Palantir's software has far more competition than Nvidia. Palantir is competing against companies that can build AI solutions in-house, consulting firms that already have deep relationships with their clients and the software engineering talent to develop these solutions, and other companies that have pre-built solutions for broad use cases.

Furthermore, Palantir will never become a product that small businesses can afford. It only has 321 U.S. commercial customers, indicating average annual spending of $2.23 million. There isn't a huge list of businesses that can spend more than $2 million annually on specific software, so Palantir's product ends up limiting itself to a certain business tier that can afford it.

Lastly, Palantir's valuation has spiraled out of control. After its latest run-up after earnings, the stock now trades for 53 times sales.

PLTR PS Ratio Chart

PLTR PS Ratio data by YCharts

A valuation of 53 times earnings is very pricey. That's an unreal valuation that will likely spell doom for the stock over the long term.

Let's say Palantir can gather a price-to-earnings ratio of 45 when fully mature. Additionally, if it can achieve a 30% profit margin (similar to other leading software companies), it would need to maintain its current revenue growth rate of 30% for the next five years.

Keep in mind that this is only for the stock to break even. For the stock to grow at a market-beating pace, it would need to grow even faster.

I doubt Palantir can maintain that momentum for five years, even if the company does well over that same time span.

Palantir is a fantastic company that's leading the way in AI, but the expectations are just too high, and I think investors would be better off avoiding the stock and moving to a different investment.

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Keithen Drury has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia and Palantir Technologies. The Motley Fool has a disclosure policy.

Disclaimer: For information purposes only. Past performance is not indicative of future results.
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