Here’s why investors should approach Palantir with caution

Palantir Technologies Inc.(NASDAQ: PLTR) has emerged as one of 2024’s standout stocks, with gains exceeding 185% over the past year, driven largely by the rapid expansion of its AI-powered platforms and increasing demand for data analytics solutions. 

However, as Palantir prepares to release its Q3 earnings on November 4, the company’s elevated valuation and reliance on continued momentum in the AI sector call for a cautious approach from investors.

Although Palantir has consistently reported strong growth figures, including a 27% year-over-year revenue increase in Q2 and an impressive 81% gross profit margin, surpassing even Nvidia’s (NASDAQ: NVDA) 75%, its current valuation poses challenges that should not be overlooked.

Key fundamentals and partnerships driving momentum

The key to Palantir’s growth has been its commercial-focused AI platforms, notably Foundry and the Artificial Intelligence Platform (AIP), which saw a substantial 55% growth in U.S. commercial revenue last quarter. 

Part of Palantir’s recent stock momentum can also be attributed to its addition to the S&P 500 index, along with a series of strategic partnerships and significant contract wins. 

Notably, Palantir partnered with Edgescale AI to launch Live Edge, a platform that combines Palantir’s Edge AI capabilities with Edgescale AI’s infrastructure technology to support AI applications in manufacturing and utilities. 

Furthermore, Palantir secured a $99.8 million military AI contract from the DEVCOM Army Research Laboratory, underscoring its appeal in the defense sector. 

Additionally, the company recently teamed up with L3Harris (NYSE: LHX), a leading defense contractor, to develop AI-enhanced solutions for U.S. and allied national security operations.

These contracts and collaborations are pivotal for fueling Palantir’s growth, although concerns around its high valuation have led some analysts to take a more cautious stance.

High valuation signals caution

The collaboration has contributed to Palantir’s rising annual guidance, which the company has revised upward twice this year.

As of the second quarter, Palantir projected 2024 revenue between $2.742 billion and $2.750 billion, up from earlier forecasts of $2.677 billion to $2.689 billion. This robust performance has strengthened investor sentiment, but Palantir’s high valuation multiples remain a significant concern.

Trading at around 33 times forward sales and 113 times forward earnings, the stock is priced aggressively, reflecting elevated growth expectations.

Additionally, a PEG ratio of 4.62 suggests overvaluation relative to growth potential, while a low free cash flow yield of 0.69% and an earnings yield of 0.40% indicate limited immediate returns for investors.

Furthermore, a short interest of 4.36% highlights market skepticism, signaling that some investors are betting against Palantir’s ability to sustain its current valuation levels.

Given these stretched multiples, it is uncertain whether Palantir can sustain its rally by simply meeting quarterly targets. 

As Palantir’s Q3 earnings approach, investor focus will likely shift to whether the company raises its full-year guidance once again, as a standard earnings beat may not be sufficient to satisfy market expectations. 

Stock analyst Jake Ruth has also noted that Palantir’s valuation above $40 is “very expensive,” cautioning that such multiple expansion cannot continue indefinitely. 

“Multiple expansion can’t continue forever,”-Jake Ruth.

At the close of the latest trading session, Palantir’s stock was priced at $44.86, up nearly 3% for the day. With shares approaching the $45 mark, investors remain optimistic and are eyeing $50 as a potential target by the end of 2024.

Limited addressable market and rising competition

Despite Palantir’s expanding footprint, its high average revenue per U.S. commercial customer, at around $2.15 million annually, suggests a limited addressable market focused primarily on large corporations with substantial data needs. 

This narrow focus could hinder broader market expansion, particularly as Palantir faces increasing competition from major players like Google Cloud, which also offers AI-driven data solutions tailored for large enterprises.

Adding to these concerns, recent insider sales have raised cautionary signals. Although insider selling does not always indicate a bearish outlook, these large transactions by top executives may suggest doubts about the company’s ability to sustain its current rally

While Palantir continues to be a compelling growth story, investors would do well to approach it with a balance of optimism and caution, ensuring the company’s fundamentals align with its ambitious valuation.