The hype around artificial intelligence (AI) has gone into overdrive, and taken Palantir Technologies (PLTR -0.59%) stock with it. A software and analytics provider for big business and the United States government, Palantir is now the 22nd-largest company in the world measured by market capitalization. The stock is up close to 600% in the last year.
Investors have fallen in love with Palantir. However, analyst estimates have a price target of $150 for the stock versus $180 as of this writing on Aug. 7. This could mean Palantir stock is set to fall 17% from highs.
In fact, I think the downside may be even more severe. Here's why shareholders should consider dumping Palantir after its monster run.
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A great business with accelerating growth
The underlying business of Palantir is doing remarkably well. Revenue growth accelerated to 48% last quarter, hitting $1 billion. That is around $4 billion when annualized to a full year.
Some of its other segments are doing even better. United States commercial revenue grew an astonishing 93% year over year to $306 million, with 157 deals closed worth more than $1 million in the period.
On the whole, Palantir signed on $2.27 billion in contract value for the period, up 140% year over year.
Profit margins are increasing even though revenue growth is accelerating, which is atypical due to increased costs needed to support fast-growing sales. Palantir had a 27% operating margin last quarter, or $269 million in operating earnings. Annualized, that is more than $1 billion in operating income for the company.
At the end of 2023, Palantir had a market cap of just $13 billion, making it a great time to scoop up shares when you compare it to the business' current earnings output.
So what's the problem? It is not what Palantir's business is doing, but the stock getting way ahead of itself.
Limited addressable market versus size of the stock
Palantir offers businesses and the government analytical and monitoring solutions, custom-built for each enterprise. This is a valuable asset for organizations with tons of data to parse.
However, it does not have a limitless addressable market. For one, Palantir is only valuable for very large companies, and it's only available to use for the U.S. government and its allies. This cuts down the long tail of addressable customers, at least today.
Second, the company's current market cap does not justify even the largest addressable market assumptions.
Let's use a comparable company such as Salesforce to illustrate. Salesforce is a software platform for marketing departments and sales organizations, of which there are millions around the United States (not to mention globally). It generated close to $40 billion in revenue over the last 12 months and looks to steadily grow in the years to come.
Palantir is generating $4 billion in annualized revenue based on this last quarter and is valued at a market cap of $425 billion, which is close to double Salesforce. That is 10% of the revenue but double the market cap, for a price-to-sales ratio (P/S) topping 100.
Palantir has by far the most premium valuation of any software stock out there today, especially if you consider only the largest software businesses in the world.
PLTR Revenue (TTM) data by YCharts
Why you should sell Palantir stock
Being generous, a reasonable price-to-earnings ratio (P/E) for a recurring revenue software business is 30. That is a 30x multiple of the market cap to trailing earnings.
Over the last 12 months, Palantir generated $763 million in net income and is on a $4 billion revenue run rate. Staying ultra-optimistic, let's assume that Palantir can grow its revenue at a 50% annual rate for the next five years and juice its net income margin to 40% (which would be best-in-class for the industry). In seven years, Palantir would be generating a staggering $30.3 billion in revenue and $12 billion in net income, or a P/E of 35 based on the current market cap.
Even making the most optimistic assumptions doesn't provide investors with positive forward returns from today's stock price. The math just simply doesn't compute for Palantir to deliver reasonable returns for shareholders going forward. Even though the stock has been a monster winner, investors would be wise to trim, sell, or avoid buying Palantir stock at today's trading prices.
