This Artificial Intelligence (AI) Stock Is Surging After Joining the S&P 500. Can It Continue to Skyrocket?

Key Points

• Datadog stock has gone parabolic in the past three months, and it recently shot up following the news of its inclusion in the S&P 500 index.

• The stock is trading at an expensive valuation right now.

• Datadog's lucrative addressable opportunity suggests that it may be able to justify its valuation in the long run.

• 10 stocks we like better than Datadog ›

Shares of Datadog (NASDAQ: DDOG) shot up nearly 15% on July 3 after it was revealed that the provider of cloud-based observability, monitoring, and security solutions will join the S&P 500 index on July 9.

Datadog will be replacing Juniper Networks in the index after the latter was acquired by Hewlett Packard Enterprise. It is easy to see why Datadog's inclusion in the index has sent its stock soaring. To enter the index, a company needs to demonstrate solid profitability in the past four quarters, along with enough liquidity.

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Datadog's inclusion in the S&P 500 over other contenders is a positive for the stock, as it demonstrates the market's confidence in the company. It's also worth noting that the stock has shot up a remarkable 76% in the past three months following its latest surge. Does this mean it is too late to buy Datadog stock? Let's find out.

Image source: Getty Images.

Datadog's rally has made the stock expensive

Datadog's cloud-based observability platform allows customers to monitor their cloud activity across servers, databases, and applications to detect issues, while its security features scan for vulnerabilities so that they can be fixed quickly. The demand for Datadog's cloud observability solutions has been rising at an impressive pace, thanks to the secular growth of the cloud market.

Now, the company is also providing tools for monitoring large language models (LLMs) and other artificial intelligence (AI) applications. The company is targeting lucrative end markets that are currently worth around $80 billion. This indicates that it has a lot of room for long-term growth. It has generated $2.8 billion in revenue in the trailing 12 months.

However, investors will now have to pay a rich premium to buy into Datadog's potential growth. That's because it is now trading at a whopping 330 times trailing earnings. Though the forward earnings multiple of 82 is significantly lower than the trailing multiple, it is still on the expensive side when compared to the S&P 500 index's average earnings multiple of 24.

The price-to-sales ratio of 20 is over 6x the index's average sales multiple. The only way Datadog stock can sustain its impressive stock market momentum is by delivering stronger-than-expected growth and outpacing Wall Street's growth expectations. But can the company do that?

Datadog's growth could accelerate thanks to AI

We have already seen that Datadog is scratching the surface of a massive end-market opportunity in the cloud observability market. The advent of AI is likely to help it corner a bigger portion of the addressable market on offer by opening up a cross-selling opportunity. Datadog had 30,500 customers at the end of the previous quarter, and 4,000 of them have been using one or more of its AI services.

Importantly, Datadog management says that this number doubled on a year-over-year basis in the previous quarter, and the good part is that this trend is likely to continue. After all, customers are flocking toward Datadog to improve the performance of their LLMs with its observability solutions. The company points out that "the number of companies using LLM Observability has more than doubled in the past 6 months."

That's the reason why Datadog is now pushing the envelope on the product development front by bringing new AI-focused solutions to customers. Its Bits AI platform helps customers investigate incidents, fix code, and review security alerts autonomously. All this should eventually allow Datadog to accelerate its growth rate in the future as the adoption of AI applications in the cloud increases.

For instance, the size of the LLM market is expected to jump by more than 6x by 2030, which should lead to an increase in the demand for Datadog's offerings. Not surprisingly, analysts are forecasting an acceleration in Datadog's growth going forward.

DDOG Revenue Estimates for Current Fiscal Year data by YCharts.

This improvement in the company's top-line growth is expected to filter down to the bottom line as well, as shown in the chart below.

DDOG EPS Estimates for Current Fiscal Year data by YCharts.

However, don't be surprised to see Datadog's earnings grow at a faster pace than Wall Street's expectations as a large chunk of its existing customer base is yet to adopt its AI solutions. This huge cross-selling opportunity should enable the company to win a bigger share of existing customers' wallets and improve its margin profile.

Datadog seems to be in a position to justify its expensive valuation by stepping on the gas. That's why it could entice growth-oriented investors, even after the impressive gains that it has clocked in recent months.

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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Datadog. The Motley Fool has a disclosure policy.