Is Palantir Stock a Buy After Falling Sharply on Friday?

Key Points

• Shares fell after a Reuters report flagged security issues in an Army communications prototype involving Palantir.

• The stock's reaction illustrates how high expectations can amplify stock price fluctuations in response to even minor business setbacks.

• For now, exceptional business performance helps justify an extreme stock valuation.

• 10 stocks we like better than Palantir Technologies ›

Palantir Technologies (NASDAQ: PLTR), a leading artificial intelligence (AI) data platform specialist, saw its shares fall about 7.5% on Friday. A Reuters report said an internal U.S. Army memo warned that a next-generation battlefield communications prototype -- built by Anduril, Palantir, and other partners -- had "fundamental security" issues. The disclosure sent Palantir's shares sharply lower.

Palantir and Anduril both pushed back quickly. A spokesperson from Anduril said in a statement provided to Reuters that any concerns were already addressed and that the memo did not reflect "the current state of the program." And a Palantir spokesperson went further, telling Reuters that there were "no vulnerabilities found in the Palantir platform."

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Even if the stock recovers early next week as investors digest Palantir's statement to Reuters about there not being any issues with its platform, the extreme market reaction is, in and of itself, informative: When expectations are sky-high, even a whiff of product risk can hit the stock.

Image source: Getty Images.

Understanding Palantir's valuation

To Palantir's credit, there's good reason for the tech company's lofty valuation. The business is downright exceptional. Case in point: Palantir's most recent quarter. After posting 39% revenue growth in the first quarter, the company's revenue growth rate accelerated to 48% in Q2, and management raised its full-year revenue outlook by about $250 million.

Even more, Palantir is pulling off this staggering growth while demonstrating substantial operating leverage. Palantir's income from operations grew much faster than revenue in Q2, increasing from about $105 million in the year-ago quarter to $269 million.

With a business like this, why should investors be concerned? The problem isn't momentum -- it's what investors are paying for it. Even after Friday's sharp drop, the stock price implies very high expectations. For context, Palantir's market capitalization at market close on Friday was more than $410 billion, despite trailing-12-month revenue of approximately $3.4 billion and net income for the same period of $763 million. Those figures pale in comparison to its market cap.

For now, the company's second-quarter year-over-year growth rates for U.S. commercial and U.S. government revenue of 93% and 53%, respectively, are high enough to support extremely bullish sentiment for the stock. But maintaining near-triple-digit increases in U.S. commercial revenue will get tougher as the base of revenue grows larger. And while profitability is improving fast, generally accepted accounting principles (GAAP) earnings are still in the early innings relative to the company's valuation.

A decline this sharp in Palantir's stock price over an alleged product issue shows how even small cracks in the bull case can spook investors. And the high expectations baked into the stock's valuation today will likely continue amplifying market reactions going forward.

A buying opportunity?

So, is Friday's sell-off a buying opportunity? I personally don't think shares are trading at an attractive enough valuation, even after the pullback. Even more, the sell-off is arguably a byproduct of the extreme expectations built into the stock -- and a proof point that more sell-offs like this could occur in the future, potentially creating a more attractive entry point for investors.

Of course, this isn't a market timing call. There's no guarantee Palantir shares will ever fall to a price that looks reasonably valued. But it doesn't hurt to be patient anyway if shares seem overvalued.

Finally, it's always possible that Palantir's business will exceed my expectations and actually live up to the stock's high valuation. But given just how extreme the stock's valuation seems today, I believe the downside risks are too great, and missing out if things go better than expected is a risk I'm willing to take.

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Daniel Sparks and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Palantir Technologies. The Motley Fool has a disclosure policy.