There's no denying the potential for artificial intelligence (AI) to alter the technology landscape in ways that we don't yet comprehend. These sophisticated algorithms are being used to automate tasks, analyze data, and even write computer code -- all of which promise to make businesses more efficient. Unfortunately, there's no consensus on the best way to implement AI, particularly for managers seeking the best return on their investment.
Investors are equally divided. On one side of the argument are those concerned that rising valuations of some AI stocks will hamper future returns, while the other camp argues that exceptional returns should command premium valuations.
One company that epitomizes this tug-of-war is Palantir Technologies (PLTR +2.13%). The company has emerged as one of the leading providers of AI systems that extract siloed information, delivering data-informed solutions to company-specific business problems.
One analyst has just crunched the numbers and concluded that Palantir is undervalued.
Image source: Getty Images.
Context is key
The popular narrative is that Palantir is overvalued, and it's easy to understand why. The stock has a price-to-earnings (P/E) ratio of 131. For comparison, the S&P 500 (SNPINDEX: ^GSPC) has a multiple of 32. It's important to note that the P/E ratio offers a way to evaluate the stock price relative to the company's profits. However, since it is a backward-looking metric, it tends to struggle with companies that are growing profits quickly.
Such is the case with Palantir. In the first quarter, its revenue grew 85% year over year to $1.63 billion. This marked the fastest year-over-year growth rate thus far and the 11th consecutive quarter of accelerating revenue growth. Moreover, the company's expanding operating margin -- at 46% and growing -- sent more profits to the bottom line, driving Palantir's earnings per share (EPS) up 325% to $0.34, up from $0.08 in the prior-year quarter.
Given Palantir's accelerating growth as context, it's easy to see why the commonly used P/E ratio falls flat.
What Wall Street is saying
Palantir recently held its AIPCon -- the company's customer-focused technology conference that uses real-world case studies to demonstrate the utility of its AI systems. More specifically, it highlights the benefits of ontology, Palantir's process for mapping its AI systems to siloed company data and physical operations. In doing so, the system taps a company's own data to create decision-making matrices, automate supply chains, optimize manufacturing operations, and much more.
UBS analyst Karl Keirstead attended AIPCon, interacting with Palantir's customers and their company executives, and believes investors' simplistic evaluations don't do Palantir justice. The analyst noted that the "complexity and depth" of its systems have no real competition.
NASDAQ: PLTR
Key Data Points
At the heart of his bullish take is that Palantir's offerings go far beyond "large language model (LLM) deployment, data ingestion, and semantic layers." Customers Keirstead spoke to said no LLM can replace Palantir for data workloads. One even suggested that AIP's ability to integrate deeply with complex systems and turn AI-driven insights into real-world solutions gives Palantir a "five-year moat."
Finally, the analyst said that at 46 times its 2027 estimated free cash flow (emphasis mine), "we believe Palantir shares are undervalued relative to medium-term growth."
Is he right?
I believe the analyst hit the nail on the head. Palantir recently raised its full-year forecast and is now guiding for revenue of $7.66 billion, which would represent year-over-year growth of 131%, driving adjusted operating income of $2.25 billion, an increase of 97%. Management is also guiding for free cash flow of $4.3 billion at the midpoint of its guidance, or growth of 89%.
My go-to metric for high-growth companies is the price/earnings-to-growth (PEG) ratio, which adjusts the P/E ratio for a company's expected earnings growth. This provides insight into whether a premium stock price is warranted. Palantir returns a multiple of 0.46, when any number less than 1 suggests a stock is undervalued. This metric supports the analyst's view.
If the analyst is right -- and I believe he is -- then Palantir has no real competition, and concerns about its premium valuation are unjustified. That said, the stock simply may not be for everyone.
For my money, however, Palantir stock is a buy.
