Are Palantir shares worth buying?

It was a good year for Palantir (NYSE: PLTR) shareholders. A data analytics company that offers specialized artificial intelligence (AI) platforms for the military, intelligence agencies and large corporations has achieved phenomenal revenue growth and is finally turning a profit. As conflicts escalate around the world, Palantir’s tools benefit the United States and its allies.

Since the beginning of the year, the company’s shares have increased by as much as 115%, and their growth shows no signs of slowing down. Investors love the speed at which it is adding new customers, its focus on artificial intelligence and its growing profitability.

But can the shares be bought now?

AI analytics for the Department of Defense and corporations

When Palantir started in 2003, its plan was to provide big data analytics software to the U.S. Department of Defense and intelligence agencies such as the CIA in the global war on terrorism. Competing with legacy products, the company won numerous contracts thanks to its modern and rapidly improving software tools. U.S. government revenues reached $278 million last quarter. Given the size of the U.S. defense budget, Palantir’s sales to Washington have plenty of room to grow.

Management built on government victories to expand into the commercial sector with great success. There’s no better marketing than saying your software is good enough for the U.S. military and the CIA, and a steady stream of enterprise customers sign deals with Palantir. Last quarter, the company’s total commercial revenue increased 33% year-over-year to $307 million.

Palantir’s customer base grew 41% year over year. This is important due to the “land and expander” business model. Once the company is founded, customers spend more and more money on Palantir services each year. These growing relationships should provide him with sustainable revenue growth for many years to come.

Watch your profit margins grow

Investors’ biggest concern about Palantir when it went public a few years ago was profitability. The company reported strong revenue growth, but its financial results were severely negative.

In just two years, Palantir has gone from a negative operating margin of 40% to a 12% operating margin in the last 12 months. In the last quarter, this percentage increased to 16%. Given the low variable costs of software, Palantir’s business model should provide enormous operating leverage. As a company matures, investors can expect operating margins to increase.

Software companies have tons of operating leverage. For example, Adobe has an operating margin of over 35%. If Palantir finally manages to reach this level, it will generate a lot of profits.

However, this assumption alone does not make Palantir stock worth buying. Valuation always matters in investing, and investors need to be clear about the valuation expectations for Palantir stock following its impressive rise.

PLTR revenue data (TTM) by YCharts.

There is excessive optimism in Palantir’s broth

Palantir’s stock is overvalued – it’s simple. Its market capitalization is $82 billion, which is absurd compared to its financial fundamentals.

The company’s trailing 12-month revenue was $2.48 billion. In the last quarter, it increased by 27% year-on-year. Assuming phenomenal business results, Palantir’s revenues could grow – a task that becomes increasingly difficult as revenues rise, that’s the nature of math – to 40% growth over the next five years.

This would mean the company’s annual revenue would be $13.3 billion. But again, this is based on an astonishing level of growth over a five-year period and a scenario that I would be surprised to see come to fruition. But let’s assume that Palantir can do this, and then at the same time it can also increase its profit margins to 40% – which is higher than Adobe and an extremely optimistic forecast. In five years, that would give it annual profits of $5.33 billion.

If market capitalization had remained at $82 billion this entire time, Palantir’s five-year price-to-earnings ratio (P/E) would have been 15.3 in this unlikely scenario. So assuming a massive acceleration in revenue growth and incredible operating leverage, the business would have grown to an earnings rate that was barely cheap compared to the long-term average earnings rate of the stock market.

This shows how overvalued this stock is currently and explains why investors should avoid it. Even if the business crushes it, shareholder returns are likely to be modest over the next five years, if not longer.

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Brett Schafer has no position in any of the companies mentioned. The Motley Fool has positions in and recommends Adobe and Palantir Technologies. The Motley Fool has a disclosure policy.