Investors in Palantir Technologies (PLTR 6.79%) have been on a roller-coaster ride lately as shares in the data analytics company have retreated by a whopping 32% from an all-time high of $124.6 reached last month.

While the stock remains a way for investors to bet on the fast-growing artificial intelligence (AI) opportunity, these declines come as no surprise to those who have been pointing out Palantir's uncomfortably high valuation. So what comes next? Let's dig deeper to see what the next 12 months could have in store.

Why did Palantir rally in the first place?

It's impossible to pinpoint a single cause for Palantir's rocket-ship rally. However, with shares up by around 67% since Nov. 5, Donald Trump's election victory has been a catalyst for the stock. But while Palantir's co-founder, Peter Thiel, has a good relationship with the president (he raised money for the campaign and even introduced him to his vice president, JD Vance), it is hard to see how these things will directly create shareholder value.

In many ways, the Trump administration's policy could reduce demand for Palantir's services, which include data analytics for military contexts.

For example, Palantir helps the Ukrainian armed forces with combat targeting against Russia. Under the leadership of new Defense Secretary Pete Hegseth, the Pentagon has proposed cutting 8% of its budget in each of the next five years (around $50 billion each year). If this move goes through, it could dramatically shrink the pocketbook of one of Palantir's core clients.

Operational performance is decent but not spectacular

There is some silver lining to the situation. For starters, Palantir is an AI company, which means its defense opportunity may be spared from drastic cuts as the Pentagon reorients toward next-generation combat capabilities. The company also has significant commercial operations that can help drive growth, even if the government opportunity shrinks.

Fourth-quarter revenue grew 36% year over year to $828 million, helped by a 64% jump in U.S. commercial revenue to $214 million (26% of the total). While Palantir's commercial business currently makes up a small percentage of total revenue, the opportunity is growing rapidly as more companies incorporate data analytics and AI into their decision-making processes.

Image source: Getty Images.

That said, when it comes to profitability, Palantir still has a lot of work to do. While fourth-quarter adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) grew 46% to $379.5 billion, this figure adds back a jaw-dropping $281.8 million in stock-based compensation.

Stock-based compensation is equity given to employees. And while it can motivate talent, it also dilutes existing shareholders by reducing their ownership claim on the company. In Palantir's case, the level of dilution looks excessive at around 34% of total revenue. This problem is worsening, with the total amount of stock-based compensation more than doubling compared to the prior-year period.

Investors should expect more downside

With a forward price-to-earnings (P/E) multiple of 147, Palantir stock looks overvalued. To put that figure in context, the S&P 500 has an average forward P/E of 22, while AI industry leader Nvidia reports just 28 despite enjoying a substantially higher growth rate of 78% in the fourth quarter.

Palantir's valuation doesn't account for the risks it faces from Pentagon downsizing. And its extreme stock-based compensation will dampen per-share earnings growth under generally accepted accounting principles (GAAP). Investors who buy Palantir stock now face profound downside risk.