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Here’s what the recent selloff means for software valuations going forward

May 19, 2022, 4:10 PM UTC
The selloff of tech stocks has dragged down markets–but it offers investors an opportunity to reassess their holdings.
Xinhua - Wang Ying - Getty Images

Software stocks have performed exceptionally over the past few decades. By the end of 2021, the software industry had reached an elevated valuation level, prompting many observers to worry about a potential tech bubble.

As markets internalized expectations of a high-interest rate environment, software valuations seem to have given up all the premium acquired during the pandemic and are now roughly at the pre-pandemic levels.

There are several factors that could continue to drive volatility in the near term. Inflation and interest rate dynamics are not yet settled. The conflict in Europe could snowball into a broader economic concern. We could also see some post-pandemics pullback in technology demand.

While these factors are looming over the tech industry in the near term, the underlying engine for growth is far from broken. Digitization and automation are still expanding trends.

Tech industry data provider Gartner estimates that Cloud computing represents around 38% of enterprise technology spending in key market segments, providing ample growth runway for the future.

The case for tech’s high valuation multiple

Software businesses grew much faster than the broader S&P500 from 2016 to 2021. The valuation-multiple expansion was a major driver of value expansion for the software industry. According to Bloomberg data, revenue-based valuation expanded by 151%, implying that the market was willing to pay 1.5x more for every dollar of software revenue as compared to 2016. Even the earnings-based valuation expanded by 54%.

There are fundamental factors that have long supported the argument for a higher valuation multiple for the software and technology industry, such as rapidly increasing levels of digitization and the pivot to cloud computing.

Additionally, the Covid-19 pandemic brought two-fold benefits to tech stocks. First, the pandemic-induced pivot to work from home drove massive demand for software. Then, investors in sectors that were negatively impacted by the pandemic rushed into beneficiary sectors like software and technology.

Digitization is transforming every aspect of our lives. The wallet share of technology spending has increased among both consumers and businesses. Over the last two decades, the use of software has been democratized. Software and technology used to be a source of competitive advantage reserved for large enterprises. These are now business essentials, available and used by businesses of every size.

The pivot to the cloud computing model precipitated generational benefits for software companies. As cloud computing is a rental model, it saves enterprise users from the cumbersome process of assembling technology stack and making huge upfront investments. Thus, converting an upfront investment into a pay-as-you-go or rental model.

Cloud models allow software companies to increase their share of customers’ technology spending by vertically integrating the technology stack into a single ready-to-use package. This vertical integration can expand the revenue opportunity, thus expanding the market size and growth runway. Major software companies like SAP and Oracle have talked about a 2-3x revenue lift from cloud migration.

Traditionally, software companies generated revenue by selling licenses. License sales tend to have higher revenue volatility due to product cycles, prevailing economic conditions, product acceptance, and other market factors. As cloud computing is a rental model, with recurring revenue, it lowers the revenue volatility for software/Cloud businesses.

There are multiple other tangible and intangible advantages of the cloud business model for software vendors, such as lower piracy, better visibility into the end-users, and potentially higher cost-efficiency.

Over the past decade, the successful adoption of cloud computing and recurring revenue models has massively expanded the value of some of the traditional software companies like Adobe and Microsoft and created new giants like Salesforce.com and Workday.

In a recent earnings call, Microsoft’s CEO Satya Nadella commented that ” As a percentage of GDP, tech spend is, on a secular basis by the end of the decade, going to double.”

The recent selloff provides an opportunity for investors to reevaluate and own high-quality software assets–particularly the ones with a strong product portfolio in Cloud, large market opportunity, and demonstrable path to profitable growth.

Firoz Valliji is a senior research associate specializing in global software at Bernstein.

The opinions expressed in Fortune.com Commentary pieces are solely the views of their authors, and do not reflect the opinions and beliefs of Fortune.

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