High demand is accelerating Palantir's growth.
By any reasonable standard, Palantir (PLTR -1.56%) is a success. The company owns one of the best artificial intelligence (AI) software application platforms on the market, and it's the leading company integrating AI models into its business to drive decision-making. This advantage has led to the company's revenue growth accelerating quarter after quarter, making it a popular stock among AI investors.
But there's one factor some investors aren't taking into account: Palantir's inflated valuation, which investors should consider very carefully, especially when considering a new investment in this dynamic company.
Palantir's business has been a huge success.
Palantir has been in the AI software market longer than its competitors, which may explain its success: Palantir's software was originally targeted at governments, deployed in intelligence agencies and battlefield command centers to ensure the best information is available to those making decisions.
Eventually, executives realized the software had uses beyond government and expanded into the private sector. While government revenue still accounts for more than half of Palantir's total revenue, the commercial side is growing rapidly, too.
The commercial growth revolves around “unprecedented demand” (in management's words) for the company's Artificial Intelligence Platform (AIP), which enables customers to integrate AI (including large-scale language models) across their businesses, automating processes like never before and incorporating human approvals where necessary.
The possibilities for AIP are truly limitless, and growth has been particularly impressive in the United States. In Q2, U.S. commercial revenue was Palantir's fastest growing segment, growing 55% year over year to $159 million. Still, Palantir's other segments didn't fare much better, with overall commercial revenue up 33% year over year and government sales up 23%. Overall, this translated into a growth rate of 27%, continuing a trend of accelerating revenue growth.
PLTR Revenue (Quarterly YoY Growth) Data by YCharts
Revenue growth is great, but the faster revenue growth, the better. Another plus for Palantir is that it's a highly profitable company. In the second quarter, the company achieved a 20% margin, a record for the company.
Palantir is doing everything it needs to be to be a successful company and more, so it's no wonder so many investors are excited about the company.
But this stock has an Achilles heel that everyone should be aware of.
Expectations are extremely high for this stock
All of the above is well known in the market, and as a result, stock prices have soared to incredible heights.
PLTR PE Ratio (Forward) data from YCharts
At 90 times forward earnings and 31 times revenue, that's an incredibly high valuation. Palantir is growing fast, but those kinds of prices only come with companies that are doubling or tripling their revenue every quarter. That's not what Palantir is doing, and that worries me.
If we assume that Palantir's growth rate accelerates to 30% year over year and stays that way for five years, Palantir's annual revenues would reach $9.2 billion by 2029. If profit margins improve to 25%, profits would reach $2.3 billion.
Dividing this number by Palantir's current market cap gives us a price-to-earnings ratio in 2029 of 31 times projected earnings.
So, for Palantir to get back to valuation parity with other large software companies, it would need to improve its margins to 25% and grow at a sustained 30% pace — a Herculean task, and one I'm not convinced Palantir can achieve.
As a result, I think the stock is overpriced and I'm not buying it. Palantir will continue to be a successful business, but the growth expectations priced into the stock are too high for my liking.
Keithen Drury has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Palantir Technologies. The Motley Fool has a disclosure policy.
