Software Sector: A Performance Review
Those who maintained their software holdings throughout 2023 following a challenging 2022, are likely pleased with the outcome. The sector has demonstrated a robust recovery over the past year, emerging as a leading market performer.
This significant price appreciation warrants a closer look at current valuations and future potential.
The average price-to-earnings for US software companies currently sits at 62x, considerably higher than its a decade-long a mean multiple 47.7x.This inflated multiple raises concerns, especially considering the sector’s projected an expansion rate 18%.
By contrast, the broader US market’s earnings valuation multiple is approximately 29x, with an anticipated profit expansion rate 14.6%. This comparison suggests that the overall market may present more compelling value.
This doesn’t automatically imply that the software industry is overvalued. However, to justify current valuations, either growth expectations must rise (surpassing 18% profit expansion), or valuations may need to decrease to match existing growth forecasts. Failure to do so could lead to underwhelming performance.
Software Company Performance: A Deeper Dive
Jamin Ball’s recent analysis in The Clouded Perspective newsletter, explored Q3 financial result for cloud software businesses.
His main conclusion was that the company’s financial health is on the upswing but still has room for improvement.
As he phrased it: Regrettably, I don’t believe those early signs of growth have fully taken off yet, they have strengthened somewhat.
The chart below illustrates the trend, depicting the year-over-year, quarterly shifts in net incremental ARR within a cloud software industry.
(Note: This dataset excludes major software giants such as Microsoft, Adobe,…. while covering most Cloud-focused application software vendors.
While revenue growth has recently turned positive, it still lags significantly behind what was observed in 2021., as shown in the chart above.
Other important points to note:
Revenue Results: Median revenue only slightly surpassed analyst expectations (by a marginal 1.6 precent). This weak performance is the worst starting from 2020 and falls short of historical averages.
Future Projections: Fourth-quarter guidance also missed consensus estimates, indicating that companies are adopting a more cautious stance due to current market conditions.
Customer Retention and Growth: NRR has dropped to a low of 112%, the worst starting from 2020. NRR tracks a company’s success in keeping and expanding its existing customer base. For comparison, this metric held normal at 120% throughout 2021 and 2022.
NRR Standards: According to Jamin, an NRR above 130% is considered top-tier, between 115% and 130% is strong, while anything under 115% is considered below par.
These figures suggest ongoing challenges for the software sector. However, the resurgence of positive ARR growth indicates a potential rebound in corporate software spending.
Monitoring these metrics in the coming quarters will be crucial to determine if this recovery gains momentum.
For a more detailed analysis of individual cloud software company metrics, the complete article is recommended.
Key Factors to Consider When Evaluating Software firms
The trends discussed above figures illustrate the broader performance of the software sector. Naturally, individual companies will exhibit varying degrees of performance, with some faring better than others.
When evaluating specific software firms, non-financial considerations often carry more weight than quantitative metrics.
In many instances, at the point when the financials appear strong, the market has already priced them in. That’s why, before diving deep into the financials, it’s crucial to grasp the business itself—its products, competitive positioning, and the broader industry landscape.
While these qualitative factors are relevant to most industries, they are especially critical when evaluating software companies.
- Product leadership
- Overall Market Opportunity
- Switching costs
- Customer Concentration
- Cross-selling opportunities
- Partnerships
- Talent retention
Hope this helps! Let me know if you need anything else.
