2023-12-08 15:54:40 ET
Summary
- Valuing high-growth stocks is difficult due to limited historical data, lack of profit, and uncertain growth curves.
- Palantir Technologies Inc.'s P/E ratios are practically meaningless, ranging from 69x to 250x depending on your interpretation of its EPS.
- Two methods are applied on Palantir Technologies for a more subjective assessment: a so-called acid test and its insider activities.
- Results from both methods raise concerns for Palantir Technologies Inc.
Valuing growth stock is hard
It is very difficult to value high-growth stocks. Most of the metrics that investors rely on simply stop working for a variety of reasons. These stocks have very limited historical data, little profit (or no profit at all), and a very uncertain growth curve. As a result, common multiples such as P/E, dividend yield, P/cash, et al are not applicable.
And Palantir Technologies Inc. (PLTR) is an excellent example, as you can see from the chart below. Its P/E ratios, depending on the basis you use (Non-GAAP TTM, Non-GAAP FWD, or GAAP), vary from 69x to 250x, practically meaningless. This article will describe two of the methods that I use to screen high-growth stocks. It is not a complete recipe that guarantees good picks (if such a recipe exists at all), but it has certainly saved me a ton of time sifting through these stocks and helped me avoid obvious potholes.
The first method is what I call an acid test. The test is essentially to estimate the owner's earnings via the following hypothetical thought experiment: what would be the valuation multiples if the business stops making growth CAPEX investments? BTW, you should stop reading if you subscribe to the notion of pursuing growth at any cost. I am a GARP (growth at a reasonable price) investor to the core and believe valuation ALWAYS matters.
The second method is to simply look at the insider activities. Insiders should know more about the company's prospects. Further, the company's financial information may be opaque and difficult to interpret, but reading insiders' activities requires no subjective judgments at all.
In the remainder of this article, I will detail why I see negative signs for PLTR on both fronts.
My acid test
In this test, I will first use the P/FCF (free cash flow) ratio instead of the P/E ratio, as both operating cash flow and CAPEX are less volatile and less subject to accounting interpretations than EPS. As seen in the chart below, PLTR's P/FCF flow ratio currently hovers around 80x (see the next chart below), too high by any standard in my view. And this is where the acid test kicks in. Many high-growth stocks spend a large amount on growth CAPEX, which inevitably reduces their FCF and drives up their P/FCF ratios. It is kind of unfair for these companies.
A better way to interpret their P/FCF multiple is to 1) decompose their CAPEX expenditures into two parts: the maintenance CAPEX and growth CAPEX, and 2) only include maintenance CAPEX in the calculation of FCF because only this part is the required part. The rest (i.e., the growth CAPEX part) is optional and should not be deducted from the operating cash flow. BTW, I did not invent any of this. This idea was promoted by Warren Buffett decades ago and books have been written on it (e.g., Greenwald's Value Investing ).
The difficulty, of course, then lies in how to do the decomposition. Luckily, in the case of PLTR, it doesn't matter that much because the total capital expenditure is a relatively minor part of its use of cash. As you can see from the chart below, in the most recent quarter, the company's capital expenditure was only $1.5 million, compared to an operating cash flow of more than 133 million. If you're really curious about the decomposition, my estimate shows that roughly 2/3 of its CAPEX is spent on growth and the other 1/3 is on maintenance. As such, its valuation multiple based on the owner's earnings (around 77x by my estimate) is about the same as its P/FCF ratio.
So, this leaves us with both good news and bad news. The good news is that the company operates an extremely capital-light business model (which is a huge plus). But the bad news is that its valuation multiple is still too high when it is based on owners' earnings.
Insider selling
Now onto its insider activities. The chart below displays PLTR's insider activities in the past 6 months. It is certainly not a show of confidence. To wit, the picture is completely dominated by sellers. A total of 76 insider transactions were reported during this period, and of them were selling activities. If we look more closely at the more recent transactions, we can see that a series of insider selling was reported in a price range of $20~21 in the past few weeks since Nov 22, 2023.
This price range also happens to be the range where its trading volume was the heaviest during the past few months, as seen in the chart below (the area highlighted by the yellow box). From a technical point of view, this price-volume pattern forms an effective ceiling for its stock prices in the near future. From a fundamental point of view, if the stock valuation is already too expensive at its current price ($17.2 as of this writing), then it is only more expensive in a price range of $20~$21. In this price range, its valuation multiple based on owners' earnings would be close to 100x by my estimate.
Other risks and final thoughts
Besides the issues analyzed above, there are a few other concerns worth mentioning. I see some pressure on its operating margins lately and expect such pressure to persist, but that as the company deals with an increase in salaries and stock-based compensation packages. Furthermore, I also see some risks that can impact PLTR more than its close peers. The company heavily relies on government contracts, with limited commercial market penetration at this stage. To make its exposure further concentrated, a small number of large customers (primarily the U.S. intelligence community and defense agencies) account for a significant portion of its revenue. This makes the company highly sensitive to changes in government budgeting, spending priorities, or policies.
On the positive side, as mentioned, the company enjoys an extremely capital-light business model. This model allows it to expand its existing services (such as its Foundry and Gotham segments) and develop new services without heavy CAPEX expenditures. A notable example involves its Artificial Intelligence Platform, recently released in May 2023. The platform is capable of integrating outside large language models (LLMs), like OpenAI's GPT-4 and Google's BERT, with customers' private datasets. However, we will need to wait and see if the proof-of-concept deals can eventually lead to larger agreements.
All told, my overall feeling is that negative forces are stronger in the near term, as reflected in the insiders' activities. In addition to these operation challenges, a very expensive valuation further compounds the downside risks. The value is too high in my view even when based on owners' earnings instead of FCF or accounting EPS.
For further details see:
Palantir: Insider Selling And My Acid Test