It has been a wild ride for Palantir Technologies (PLTR +0.08%) shareholders recently. The data analytics company's stock has rebounded sharply over the last 30 days, rising about 23%. But, zooming out, the growth stock is still down almost 10% year to date.
This recent surge in buying interest comes as geopolitical conflicts may have some investors concluding that demand for intelligence tools that aid governments and military operations -- Palantir's specialty -- is accelerating.
Driven by intense enterprise demand for its artificial intelligence (AI) platform, Palantir's business is scaling powerfully in recent quarters. But that doesn't automatically make it a great investment. To be a good investment, shares have to be appropriately priced. And even the fastest-growing businesses can be mispriced.
So, is Palantir stock overvalued after its recent run-up, or is its momentum just the beginning?
Image source: The Motley Fool.
Staggering top-line momentum
Looking at Palantir's fourth-quarter update, the business's momentum is downright spectacular.
The software provider's total revenue reached $1.41 billion -- up 70% year over year. And a closer look at the quarterly numbers reveals that domestic commercial adoption is the AI data company's main driver. Palantir's U.S. commercial revenue skyrocketed 137% year over year to $507 million.
And while the domestic commercial sector is booming, the company's U.S. government revenue still grew at an accelerated rate, rising 66% year over year to $570 million. This compares to U.S. government year-over-year revenue growth of 52% in the prior quarter.
Profits and cash flow are surging
Growth is important, but Palantir's ability to turn that top-line expansion into tangible profit is particularly impressive.
In its fourth quarter, Palantir produced a 41% operating margin on a generally accepted accounting principles (GAAP)-basis during the quarter, translating to $575 million in operating income. Generating that level of profitability while simultaneously growing at such a high rate is impressive not just for a software company, but for any company.
And the company continues to throw off tons of cash. Palantir generated $791 million in adjusted free cash flow during the fourth quarter alone, representing a phenomenal 56% adjusted free cash flow margin. This influx of cash has fortified the company's balance sheet, leaving Palantir with $7.2 billion in cash, cash equivalents, and short-term U.S. Treasury securities.
A borderline egregious valuation
But even the most pristine financial metrics cannot fully insulate a stock from valuation risk.
As of this writing, the growth stock trades at a price-to-earnings ratio of about 255. At this price tag, the market is not just assuming the company will succeed; it is arguably demanding absolute perfection over the long haul.
With a valuation like this, any slight moderation in its top-line trajectory could trigger a sharp sell-off. The stock simply does not offer investors a margin of safety.
NASDAQ: PLTR
Key Data Points
So, what should investors do?
While I think the underlying business is one of the strongest in the market today, the stock remains more of a hold than a buy in my opinion. And frankly, it's hardly a hold after its recent run-up. Shares were already expensive before this 30-day rally. Now, the setup is even riskier.
With all of this said, the case for holding and not selling is found in the difference between Palantir's price-to-earnings ratio and its forward price-to-earnings ratio -- a valuation metric that considers a stock's price as a multiple of analysts' consensus forecast for earnings per share over the next 12 months. While Palantir's price-to-earnings ratio currently sits at 255, its forward price-to-earnings ratio is much lower, at 116. This is because the company's underlying earnings momentum is extraordinary, and the business should do a good job of growing into its valuation over the next year.
Still, for investors who do decide to keep holding their Palantir stock, keeping the position small is probably a good idea. There's no way around it: as a software business operating in a rapidly changing, highly competitive industry, Palantir is a high-risk investment.
