Should Investors Avoid Datadog Stock?

At first glance, Datadog (NASDAQ: DDOG) may look like a stock investors want to accumulate rather than avoid. It has generally risen since early 2023, and a recent turn to profitability tends to bode well for a stock.

Unfortunately, troubling signs in the business and its valuation have raised concerns. Changing technology could alter the company's value proposition, yet the stock trades at a premium valuation. Thus, the question for investors is whether they would likely be better off investing in Datadog amid its likely challenges.

Where Datadog stands

At first glance, Datadog appears to lead an increasingly important company. The SaaS stock is one of the leaders in IT dashboards, and these monitor IT networks, allowing administrators to identify potential problems early.

Moreover, Datadog continues to add new products to the platform. Additions such as agentless scanning, data security, and code security appear to give customers more reason to increase their spending on the platform. A 13% rise in customers spending more than $100,000 annually on the platform is a sign of its understanding of customer needs.

Furthermore, revenue for the first half of 2024 was just under $1.3 billion, rising 27% from year-ago levels. Also, slower growth in operating expenses helped it earn a profit of $86 million in the first two quarters of the year. In comparison, Datadog lost $28 million in the first half of 2023.

Datadog's challenges

However, such progress may have hidden possible signs of trouble for the company. One issue is artificial intelligence (AI). Indeed, AI offers potential opportunities for the company. To this end, Datadog has introduced products such as foundation modeling through its Toto product or software that can monitor Nvidia GPUs.

Nonetheless, Datadog is not the only option for such monitoring, and customers have increasingly questioned whether its the best tool available, particularly with AI-related applications. That could be leading more prospective customers to question the need for Datadog's software.

Moreover, the aforementioned 27% revenue growth is robust and matches the 2023 revenue growth rate. Still, revenue grew 62% in 2022 and 79% in 2021. Thus, Datadog's growth rate has slowed dramatically, and since analysts forecast 24% revenue growth this year and 22% the next, its rapid growth from prior years is not on track to return.

Furthermore, Datadog stock seems to not have adjusted to that reality. Indeed, it is up for 2024, if only by 7%, and the likely reason for that lack of stock growth is the valuation.

Despite the slowing revenue increases, the stock trades at 78 times forward earnings. Additionally, its price-to-sales (P/S) ratio remains above 20. Such valuations are typically more fitting for the kind of growth Datadog experienced during and before the pandemic, making it likely the stock price will continue to stagnate or possibly fall.

Should investors avoid Datadog stock?

Considering the uncertainty surrounding Datadog stock, investors should more than likely avoid this stock.

Admittedly, Datadog looks like a successful SaaS stock despite the slowing revenue growth. It continues to attract more customers utilizing more of its products.

Unfortunately, the advent of AI could be either a catalyst for more business or a reason for customers to seek competing alternatives. Knowing that, investors probably need more clarity on how AI affects Datadog, both positively and negatively.

The other matter is valuation. Although it continues to hold a premium valuation, the 50%-plus revenue growth that attracted the premium is long gone. At current growth rates, Datadog's stock price looks to be well ahead of its fundamentals.

If Datadog continues to prosper from AI and the valuation falls, investors should reevaluate the stock at that time. Nonetheless, under current conditions, investors are probably better served by staying on the sidelines.

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