Artificial intelligence (AI) is the hottest investing theme of the moment. Much ink has been spilled on the technology's awesome power and potential economic impact. Could it be as transformative as its evangelists would have you believe? PwC -- one of the "big four" accounting firms -- believes AI can add $15.7 trillion to the global economy by 2030. If that proves to be true, it certainly meets the mark in my book.
While Nvidia took center stage, another AI company, Palantir (NYSE: PLTR) , just passed a major milestone that may help boost its profile and stock price. Founded in 2003, the company certainly isn't new, but recent advancements in AI are supercharging the company's ability to turn a profit. The company's share price followed suit, up 150% this year alone.
This made it eligible for inclusion in the S&P 500 , and Palantir officially joined the index late last month. What does this mean for the company?
Joining the S&P 500 is a big deal and may affect Palantir's stock price
The S&P 500 is an index comprised of the 500 largest companies in the U.S. by market capitalization . It's also one of the most well-known and popular indexes around -- so popular that it's often used as a proxy for the stock market as a whole. This visibility usually translates to an uptick in investment from the retail market. Some of these investors are hearing about the company for the first time, while others see its inclusion as a mark of legitimacy.
Beyond retail, however, the index is tracked by all sorts of funds , like the uber-popular SPDR S&P 500 ETF Trust or Vanguard 500 Index Fund . When a company joins the S&P, there is a flood of capital into the stock as these funds adapt to match the index.
All this leads to what's sometimes called the "S&P 500 effect" -- a bump in stock price after being included in the index. Take Nvidia, for example. The chipmaker was announced as the replacement for the crumbling Enron back in November of 2001. In the month that followed, its stock price surged more than 30%. Will this happen to Palantir?
Correlation is not causation
Unfortunately, the effect may be more of a coincidence. A study commissioned by the Federal Reserve Bank of New York looked at the effect and found that there really isn't a lot of evidence for it, or at least that any direct effect is short-lived.
Stocks that get added to the index tend to already be on an upswing. They have prior momentum. The study showed that this momentum was the primary cause of performance over the long term post-inclusion. Essentially, the positive price movement would have happened with or without being added. Still, whether it is the cause or not, the fact remains that when a company is added to the S&P 500, it tends to do well.
Palantir is promising, but beware of its valuation
The company is showing strong growth in its top-line revenue and tremendous reductions in operating expenses. This means huge upswings in its net income. Take a look at the chart showing the takeoff in 2022.
PLTR Net Income (TTM) data by YCharts
These are trends you want to see. The company is continuing to find success in the lucrative world of government contracts and announced last month that it had landed another, this time with the U.S. Army, to help overhaul its AI capabilities. The new contract means the company is now working with all five of the U.S. armed services.
Palantir's as a company looks great. Its income growth looks set to continue its rapid rise. However, its ability to make money isn't the issue. Sometimes a great company can turn out to be a not-so-great investment if it's valued too high. I think that's the case here. While valuation metrics can be wonky for a time as a company finally begins to turn a profit, I can't ignore just how out of whack its stock price seems to be.
It currently has a forward price-to-earnings ratio (P/E) of 103 and a price-to-sales ratio (P/S) of 41. Compare that to Nvidia, which is valued at quite a premium at the moment, which has a forward P/E of 46 and a P/S of 26. Alphabet 's metrics are 21 and 6, respectively.
With the stock price where it is, I can't recommend the stock to most investors. I think there are better places to put your money. However, if you are younger with a high risk tolerance and a very long time horizon, it could be an interesting play.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Johnny Rice has positions in SPDR S&P 500 ETF Trust. The Motley Fool has positions in and recommends Alphabet, Nvidia, Palantir Technologies, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy .
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