Palantir Stock: Flying Higher Than Fair Value (NYSE:PLTR)

Palantir (NYSE:PLTR) stock punches above its weight on the internet. The stock has 190,000 followers on its Seeking Alpha stock page, more than triple what the much larger Royal Bank of Canada (RY) has. For a more apples to apples comparison, contrast Palantir with Adobe (ADBE), which yields similar but less extreme results. Adobe, which has 8.8 times Palantir’s market cap, has about 60,000 fewer followers.

The point is, Palantir has a devoted following. It has never been the biggest tech company, but it has some of the most dedicated fans. On any given day on Twitter (TWTR), you can find die-hards talking about the company’s AI capabilities, industry use cases, and tendency to benefit in bad times.

Some of the points that Palantir fans make are valid. The company does, in fact, seem to benefit from tough times, as it is a military contractor. Additionally, it seems to be respected in AI, as it was invited to collaborate on Forrester’s “The Forrester Wave™: AI/ML Platforms” report.

So Palantir bulls have some definite points when it comes to the company’s capabilities. However, their takes have always struck me as overlooking business fundamentals. It seems that many people who hold PLTR are so enamored with the “idea” of the company that they ignore its business performance and valuation.

Of the two factors I just mentioned (performance and valuation), PLTR gives a mixed showing. Palantir is still growing the top line at 26%, which is impressive because a lot of big tech companies lost their previously fast growth with this year’s economic slowdown. The company also has positive free cash flow, offset by dilution. So, Palantir has no shortage of factors going in its favor.

However, when we take a look at its valuation, it becomes clear that PLTR is exposed to some risk. Even after falling 72%, the stock still trades at 8.7 times sales while being unprofitable. This is definitely not a clear cut buy. On the other hand, Palantir is one of the few tech companies still putting out 2021-style growth numbers in 2022, so it deserves a richer valuation than most of its peers. Taking all of these factors together, the stock looks like a ‘hold,’ as it may be suitable for some especially risk tolerant investors (provided they’re willing to accept short term losses before seeing a recovery much later), but not others.

Palantir: the Positives

Before getting into why I still consider Palantir very expensive after its 72% year-to-date selloff, I should mention what the stock has going for it. PLTR is no bubble stock; it is an FCF-positive company that could be GAAP profitable if the company’s executives really wanted it to be. So, the positives deserve a mention here.

First, the company is still growing pretty fast, which is worth mentioning because a lot of tech stocks lost their ultra-high growth streaks this year. For example:

• Apple (AAPL) delivered only 2% revenue growth in its most recent quarter.

• Meta Platforms (META) delivered negative revenue growth.

• Alphabet (GOOG)(GOOGL) delivered positive revenue growth but negative earnings growth.

By contrast, Palantir delivered 26% top-line growth and 71% growth in operating income. So, Palantir seems to be growing faster than other tech companies amid the 2022 tech slump.

A second thing Palantir has going for it is revenue stability. Palantir is a business-to-business (B2B) software company with long term contracts, it doesn’t have to hustle people to buy its latest consumer gadget every year. According to its 2021 investor presentation, Palantir has a weighted average contract duration of 3.5 years. This means that investors don’t have to worry about the company’s sales abruptly crashing as happened with Meta last quarter.

Finally, Palantir is embedded within some of America’s most stable and foundational institutions. Its single biggest client is the U.S. government, and within the government, defense is the largest department it does business with. The DoD is the single biggest use of government funds, and it’s the definition of an essential service. So, Palantir’s bread and butter isn’t going anywhere.

First Issue: Dilution

Having established some positives about Palantir, it’s time to get into our first negative:

Equity dilution

Palantir is constantly issuing new shares to employees and diluting existing shareholders’ ownership in the process. For example, Palantir had 2.05 billion weighted average shares outstanding in its most recent quarter, it had 1.894 billion in the prior year quarter. So, the number of shares increased 8.4%.

Dilution is a problem because it offsets growth and makes each shareholder’s ownership percentage less. Let’s say we had a company with $1,000 in earnings and 1,000 shares. That company would have $1 in earnings per share (“EPS”). Now, if earnings grew to $1,200, then it would have a 20% growth rate. However, if the number of shares increased to 1,084, the 20% growth would be reduced to 10.7% on a per share basis, because 1,200 divided by 1,084 is only 1.107. Had the number of shares stayed constant at 1,000, then shareholders would have enjoyed the full 20% growth in earnings.

Palantir executives have been saying in recent earnings calls that they intend to get the rate of dilution down. In fact, they have done so: the 8.4% dilution in the most recent quarter was way down from the 100% dilution observed over Palantir’s first year as a public company. Still, there is quite a bit of dilution going on, and it’s harming growth on a per share basis.

Valuation

The second negative with Palantir is the fact that it’s still a very expensive stock. When an asset you like goes down in price, it’s natural to start thinking about buying the dip, and Palantir is indeed a better buy now than it was at, say, $30. However, it’s still basically an expensive asset compared to the underlying fundamentals. According to Seeking Alpha Quant, PLTR trades at:

• 151 times earnings.

• 8.7 times sales.

• 6.6 times book value.

• 53 times operating cash flow.

These are all very high multiples. For comparison, the S&P 500’s P/E ratio is currently 18.43, and the long term average is 15. Palantir is far more expensive than the average stock. Of course, it’s also growing faster than the average stock, but with all the dilution that’s been happening, the growth per share is less than it looks.

I’ve done a number of discounted cash flow (“DCF”) valuations on Palantir in past articles. These kinds of models are very sensitive to inputs; I’ve gotten fair value estimates ranging from $5 to $14 depending on the discount rate used. Unfortunately, Palantir’s performance has deteriorated a bit since I last wrote about it. EPS swung from a positive figure to a negative one, and six-month operating cash flow got cut by nearly a half. Based on the previous quarter, I wouldn’t expect positive growth in earnings or cash flows any time soon. I’m not going to build a DCF model that assumes negative earnings growth indefinitely, as we’re in a recession that, if it’s like most recessions, won’t last forever. However, I can’t come up with a plausible reason to think that earnings will grow perpetually either, so for now I will just say that past DCF models I ran on Palantir yielded fair value estimates as low as $5. This stock will really need interest rates to fall dramatically in order for it to become buyable.

The Bottom Line

The bottom line on Palantir is that you really need a lot of risk tolerance, a passion for the company, and an extraordinarily long time horizon in order to justify owning it. The current rising interest rate environment just doesn’t incentivize buying assets this expensive. If, at some point in the future, the Federal Reserve starts cutting rates again, PLTR may be worth it for some investors outside of its core fan base. For now, though, it has to be said: this stock is not well suited to anyone but the most ardent believer.

That’s not to say that the Palantir bulls are wrong. Their points about the company’s “sophisticated” capabilities strike me as being fairly compelling. However, most of these points can’t be captured mathematically and entered into a valuation model. Does Palantir have great AI capabilities? Does it have an ultra-dependable client base? Does it provide services that become more important in times of geopolitical instability? The answer to all these questions is “yes.” The soft factors that Palantir bulls like to point out are indeed real, but they’re not quantifiable. On the other hand, the things about the company that are quantifiable – like the dilution and negative GAAP earnings – don’t look so hot.

So, Palantir gets a “hold” from me. The soft factors that bulls point to could eventually work in their favor, so I’m not going to say that they’re wrong. If you are very emotionally attached to PLTR and you think that its U.S. military relationships will someday rain gold on shareholders, you have a non-zero chance of being right. But if you’re somebody who doesn’t really care about any of this and is just looking to invest some capital that’s currently held in cash, you might want to look elsewhere. PLTR, the stock, is not really worth it unless you are already deeply committed to the idea of Palantir, the company.