2023 has been the year of the artificial intelligence (AI) stock, and 2024 could be another solid year for this cohort. But, a few stocks have gotten absolutely overheated and are trading at sky-high valuations. They may have a tough time hitting expectations in 2024, so it may be good to get out while you can.
One of these stocks is Palantir (PLTR 0.73%), a business that has excelled lately. In fact, I think it will do great in 2024 as well, but the stock is at a point where it is mismatched with the business.
Palantir's business is excelling
One reason Palantir has been a popular AI pick is that it has been doing AI for a long time. Since its founding in 2003, Palantir has been laser-focused on applying AI-based analysis to data flows to give the end-user the most up-to-date information possible to make a decision.
Originally, this software was developed solely for government use by intelligence agencies, defense departments, and anywhere else where critical decisions must be made quickly. Palantir eventually expanded outside government contracts and into the commercial side, further expanding its market opportunity. Still, government contracts make up most of Palantir's revenue, with 55% coming from government sources in Q3.
But that's not to say commercial revenue won't overtake it someday. Commercial revenue rose 23% in Q3 versus the government's increase of 12%. Another bright spot was the U.S. commercial customer count, rising 37% year over year from 132 customers to 181.
As mentioned, Palantir's business is doing well. I also expect this strength to continue into 2024, but the stock is valued in a way that doesn't support what the business is doing.
The stock has many years of growth baked into it already
Palantir's stock isn't cheap. While the $17 price tag may seem cheap, you must look at what that $17 is buying you. By dividing the stock price by a financial statistic (like sales or earnings), investors can see how much they pay for a share of the business.
Palantir isn't fully profitable yet, but it is steadily improving (another point in favor of Palantir's business doing well). So, I'll use its price-to-sales (P/S) ratio to value the stock.
PLTR PS Ratio data by YCharts. PS Ratio = price-to-sales ratio.
For any stock, let alone one growing at only a 17% pace, 18 times sales isn't a cheap price. While other software stocks trade around this range, many are growing revenue at a 30% to 40% pace.
Another way to look at the P/S ratio is to imagine Palantir was instantly fully profitable. A mature software company like Adobe regularly posts profit margins of around 27%, which we'll use for Palantir's hypothetical profit margin.
If Palantir could achieve that, it would trade at 68 times earnings. Once again, that's a hefty premium for a stock. Even if Palantir grows its revenue at a 17% pace for the next five years, that would value the stock at 30 times earnings. So, for Palantir to reach the range that most mature tech stocks trade at, you must give up five years' worth of gains, grow at a 17% pace, and match the profit margins in one of the most successful software companies of all time.
That's quite the bar to clear, and I'm unsure Palantir's stock can do it unless its growth rapidly accelerates. It may do that in 2024 and surprise me, but Palantir's software is as expensive as the stock and takes a while to integrate. Hence, the slow and steady business growth Palantir delivers makes sense. If the stock drops based only on valuation and not on declining business metrics, I would reconsider my stance.
Palantir is a great company that is capturing a lucrative opportunity and will likely succeed. However, the stock doesn't support the current growth pace, which makes me think investors should consider looking at some other stocks for 2024.
