Thanks to surging interest in artificial intelligence (AI) technologies and improving business performance, Palantir (PLTR 3.73%) has been one of 2023's hottest stocks. The data analytics company's share price has skyrocketed 177% across this year's trading.
In conjunction with improving margins and profitability, Palantir's return on invested capital (ROIC) is on an encouraging upward trend. Have a look at the chart below and read on to see why ROIC and weighted average cost of capital (WACC) trends are flashing bullish signals for the software specialist's stock.
Image source: The Motley Fool.
Palantir's ROIC trend looks very encouraging
The chart above uses data from New Constructs, a company that specializes in investment research and financial analysis. In order to calculate return on invested capital (ROIC), New Constructs takes a company's net profit after taxes and divides it by average invested capital.
Meanwhile, WACC is calculated by combining costs that a company has from debt and issuing new shares weighted against a company's market capitalization. The company's corporate tax rate is also a factor because interest expenses are tax deductible, but that's not applicable here because Palantir has no long-term debt. Instead, the company has leaned on stock-based compensation as an important capital source to fund its operations.
WACC being higher than ROIC is often a sign that shareholder value is being destroyed, but investors should take the long view -- particularly when it comes to growth stocks and potentially explosive plays in the AI space. Palantir's ROIC being both negative and below WACC highlights the fact that this is a high-risk stock, but these characteristics aren't unusual among specialized tech companies making big bets on categories with revolutionary potential.
Even though Palantir's ROIC remains below its WACC, long-term investors with above-average risk tolerance may find a lot to like about the trends illustrated in the chart above. Crucially, ROIC has seen encouraging upward progress, while WACC has seen much smaller jumps. A shift into positive ROIC appears to be on the near horizon, and the company's business continues to look highly scalable.
Profitability is improving and AI is powering new growth
Palantir has generally seen its margins and profitability improve substantially in recent years. The company has now been profitable for three consecutive quarters on a generally accepted accounting principles (GAAP) basis, and it expects to extend the streak. Even better, the software specialist's sales growth is accelerating again, and there's a promising demand outlook for its services in both the public and private sector.
From its founding in 2003, Palantir has been heavily focused on machine learning and AI tools. Thanks to its high-performance data analytics software, the company has been able to land contracts with the U.S. Air Force, the FBI, the Department of Health and Human Services, and other government agencies. It's also scored big wins in the private sector and counts customers including United Airlines, Citigroup, and Kinder Morgan among its client base.
Now the company is rolling out new AI technologies, and they look poised to power new growth phases for the business. For example, the company announced in September that it had won a $250 million contract with the U.S. Army for AI research and services.
Even though the company's ROIC is still negative and remains far below its WACC, these metrics still have to be viewed in context. Palantir's ROIC has seen dramatic improvements over the last few years, and the company could still be in the early stages of tapping into massive, AI-powered growth opportunities.
Palantir is an AI stock that still has explosive potential
Palantir is currently valued at approximately 73 times this year's expected earnings and 16 times expected sales. It's important to note that the company's growth trajectory remains highly speculative -- and some strong performance is already baked into its current valuation.
On the other hand, the foundations appear to be in place for the business to see strong sales and earnings expansion over the long term. Dramatic improvements for ROIC point to the company's growth being very effectively managed, and there's a good chance that Palantir is just starting to benefit from tailwinds associated with the AI revolution.
