US software stocks bucked the trend and surged Morgan Stanley: valuations are cooling down and stock selection is more critical

The Zhitong Finance App learned that Morgan Stanley recently released a valuation report on the North American software industry, maintaining a positive view on the North American software industry. However, the bank pointed out that at a time when stocks benefiting from AI capital expenditure are regaining a dominant position in the market, the investment logic of the software sector is still quite controversial. After recent adjustments, the overall valuation of the software industry is already significantly lower than the average of the past five years, but the performance threshold for high-growth and high-valuation companies is still very high, and companies that can actually cross this threshold with their performance are still limited.

Over the past week, software stocks have clearly outperformed the market. According to Morgan Stanley data, the median software sector fell 4.1% in a week, and the S&P 500 index and the Nasdaq index fell 0.8% and 0.7% respectively during the same period; judging from the year-to-date performance, the median software stock fell 6.5% cumulatively, while the NASDAQ and S&P 500 rose 13.3% and 11.9%, respectively, during the same period. Currently, the median software stock is about 27% lower than its 52-week high, indicating that the sector has experienced quite obvious valuations and stock price adjustments.

The division of individual stocks was particularly sharp. Cloudflare (NET.US) and DigitalOcean (DOCN.US) rose 9.9% and 9.3% respectively last week as the main runners; at the same time, ServiceTitan (TTAN.US), Braze (BRZE.US), and Navan (NAVN.US) plummeted 37.8%, 25.1%, and 24.3%, respectively, after announcing results. This also reflects an important characteristic of the current software stock market, that is, investors are not simply selling off the entire industry, but are increasingly screening the ability to deliver results.

As of press release, Cloudflare's stock price continued to rise by more than 6%, DigitalOcean down more than 3%, ServiceTitan up more than 3%, Braze up more than 4%, and Navan up 0.76%.

The overall valuation of software stocks has cooled down, and leading companies are still overvalued

From a valuation perspective, the software industry as a whole has experienced significant compression. According to Morgan Stanley data, the software companies it covers currently have an overall corporate value/sales (EV/NTM Sales) of the next 12 months about 5.9 times, which is about 18% lower than the average of 7.3 times the past five years. If growth factors are further considered, the software sector's current EV/NTM sales revenue growth rate in the next two years is about 0.41 times, which is also about 15% lower than the average of 0.49 times in the past five years.

But the problem is that this “cheapness” isn't evenly distributed across all software companies.

According to Morgan Stanley statistics, the average EV/sales of the five software companies with the highest valuation still reached about 28.1 times, which is about 7% higher than the average of 26.1 times the past five years. In other words, although the market has reduced software stock valuations as a whole, investors are still willing to pay a clear valuation premium for the few most sought-after high-growth companies.

This means that for software companies with currently high valuations, the market's requirements for performance delivery have also increased accordingly. Achieving good growth alone may not be enough to keep stock prices rising; companies need stronger performance and outlook guidance to justify their overvaluation.

High-growth software stocks still have high valuations and limited fault tolerance

Judging from the different growth echelons, this kind of valuation differentiation is even more obvious.

According to Morgan Stanley data, software companies that are expected to have a compound revenue growth rate of more than 25% now have overall EV/sales for the next 12 months about 12.9 times, which is only about 1% lower than the average of 15.8 times in the past five years. This means that even though real high-growth software companies have experienced adjustments, the overall valuation is actually still close to the historical average, and there are no particularly obvious “discounts.”

Looking further at specific high-growth companies, Morgan Stanley classified companies with a compound sales growth rate of more than 20% into the high-growth group. The average stock price of this group of companies is about 77% of the 52-week high. The compound sales growth rate is expected to reach an average of 31% from 2025 to 2027, but the average EV/sales corresponding to the expected sales in 2027 is still 24.9 times higher. These include Cloudflare, Zeta, CrowdStrike (CRWD.US), Snowflake (SNOW.US), GitLab (GTLB.US), SentinelOne (S.US), Samsara (IOT.US), Palantir (PLTR.US), Shopify (SHOP.US), Klaviyo (KVYO.US), and monday.com (MNDY.US).

This means that although high-growth software stocks have retreated from their highs, investors are actually still paying very high prices for future growth. Therefore, once financial reports cannot continue to prove that rapid growth is sustainable, valuation compression may quickly turn into a sharp adjustment in stock prices. ServiceTitan, Braze, and Navan's sharp decline after financial reports is a reflection of the current high performance threshold environment.

The valuation of medium-growth software stocks is still above the historical average

Notably, the valuations of medium growth companies did not show significant discounts. For software companies with a compound revenue growth rate of 15% to 25%, Morgan Stanley estimates that their EV/NTM sales are currently about 8.4 times, which is slightly higher than the average of 8.1 times the past five years, about 4%.

Under another classification method, the average stock price of medium growth software companies according to Morgan Stanley has fallen back to about 71% of the 52-week high. The compound sales growth rate is expected to be about 17% in the next two years, and the EV/sales average is expected to be about 8.3 times higher in 2027.

Therefore, for this group of companies, just because the stock price has fallen from a high level, it is not possible to directly draw the conclusion that “valuation is cheap.” The retracement in stock prices needs to be viewed in conjunction with changes in future growth expectations. If profit expectations fall at the same time, then the apparent decline may not have actually created a safe margin for valuation.

Low-growth software stocks are the ones that actually show significant valuation discounts

Compared to high growth and medium growth companies, the valuation compression of low-growth software companies is most obvious.

According to Morgan Stanley data, software companies with a compound revenue growth rate of less than 15% currently have EV/NTM sales only about 3.5 times, which is about 28% lower than the average of 4.9 times in the past five years, and is even lower than the average valuation of 4.5 times from 2014 to 2018.

Another sample of low-growth companies in the report shows that the average stock price of these companies is about 74% of the 52-week high, and the compound revenue growth rate is expected to be only about 8% in the next two years, corresponding to the average EV/sales volume in 2027 about 4.3 times. This group includes companies such as Salesforce (CRM.US), Adobe (ADBE.US), Fortinet (FTNT.US), Okta (OKTA.US), Twilio (TWLO.US), Zoom (ZM.US), DocuSign (DOCU.US), UiPath (PATH.US), and Akamai (AKAM.US).

This shows that currently the most obvious valuation discounts in the software sector are mainly concentrated on mature companies that are growing slowly.

But this also poses the problem that undervaluation itself is not a catalyst. If the growth of these companies cannot be accelerated again, then undervaluation may be maintained for a long time; companies that can actually generate more room for revaluation are more likely to be those that have been priced by the market according to low-growth companies, but can prove that growth will accelerate again in the future.

Infrastructure and cybersecurity still enjoy significant valuation premiums

Judging from the different tracks within the software, the market's preference for AI infrastructure and network security is still very obvious.

According to Morgan Stanley data, EV/NTM sales for infrastructure software are currently about 10.1 times, cybersecurity software is about 9.3 times, and SaaS companies as a whole are only about 4.4 times. The valuation gap between cybersecurity and infrastructure has narrowed, but the two still have a very significant premium over traditional SaaS.

This is in line with recent market capital flows. Beneficiary companies related to AI capital expenditure have re-emerged as market leaders, while traditional application software still faces controversy over whether AI is a growth catalyst or a potential disruptor.

Currently, there is an obvious “repricing” within the software sector, which means that companies more directly related to AI infrastructure, data traffic, and cybersecurity requirements can still obtain higher valuations, while the valuation center of traditional SaaS companies has declined markedly.

Cash flow and profit indicators show that software stock valuations have declined sharply

Without using revenue as the basis for valuation and shifting to free cash flow and profit indicators, the current level of discount in the software sector is actually more prominent.

According to Morgan Stanley data, the software industry's overall EV/free cash flow for the next 12 months (EV/NTM FCF) is about 23.2 times, about 37% lower than the average of 37.1 times in the past five years, and about 69% lower than the historical peak of 75.9 times.

Among some software companies with comparable profit data, the price-earnings ratio for the next 12 months is about 13.8 times, which is about 33% lower than the average of 20.7 times in the past five years.

If GAAP is used, the future price-earnings ratio of the overall software coverage company is about 26.1 times, which is about 14% lower than the average of 30.5 times in the past five years; for a group of more mature software companies, GAAP's future price-earnings ratio is about 21 times, which is about 30% lower than the average of 30.1 times the past five years. Measured from a profit and cash flow perspective, the software sector has experienced a more pronounced normalization of valuations than revenue multiples.

Morgan Stanley is still optimistic about the software industry, but the importance of stock selection is rising

Overall, Morgan Stanley still has a positive view of the North American software industry, but the current investment environment is clearly different from the stage in the past where it relied on valuation expansion to drive the overall sector upward.

On the one hand, the overall valuation of the software industry has fallen below the average of the past five years. In particular, low-growth companies, free cash flow valuations, and profit valuations have all shown significant discounts, providing some valuation support for the sector; on the other hand, the valuations of high-growth companies that are actually sought after by the market are still not low, which means that these companies must continue to hand over performance that exceeds the high expectations of the market.

The extreme stock price reaction after recent earnings reports also shows that the market is rapidly punishing companies that are unable to reach high performance thresholds. ServiceTitan plummeted 37.8% in a week, Braze fell 25.1%, and Navan fell 24.3%, in stark contrast to Cloudflare's 9.9% increase and DigitalOcean's 9.3% rise.