Beware The Looming Bubble In Software Stocks

Investors seeking companies with fast revenue growth are piling into software stocks such as Microsoft Corp. (MSFT), Oracle Corp. (ORCL) and Workday Inc. (WDAY), which have soared well past the broader market this year. IPO Crowdstrike Inc. (CRWD) also has posted strong gains. But some analysts say these gains may be creating a bubble in software stocks even as industry revenue grows by an average of 25% yearly, according to a detailed story in Barron’s as outlined below. 

'Bubble' like 2000

“Software valuations are at all-time highs,” Macquarie Research software analyst Sarah Hindlian, told the publication, adding, “Bubble risk rises.” Fred Hickey, editor of the High-Tech Strategist newsletter, agrees. “It’s a bubble, just like 2000,” he says. “These price/sales ratios are normally what you would see as price/earnings ratios.”

Many software companies are now valued at more than 20 times projected 2019 sales, compared to about four to eight times projected sales for big tech companies like Apple Inc. (AAPL), Microsoft, Amazon.com Inc. (AMZN) and Facebook Inc. (FB). Meanwhile, the S&P 500 index (SPY) is now valued at roughly two times sales. 

The valuations also are dizzying on a price-to-earnings basis. Cloud industry leader Salesforce.com (CRM) is in a class by itself. As of Friday, the company traded at around 200 times its projected GAAP profits for the year ending January 2020. On a non-GAAP basis, it's still pricey at 57 times projected earnings, per Barron's.

A great deal of these expensive software stocks have yet to see profits. Take for example, cloud software provider Workday, which has a market capitalization of nearly $50 billion but is still posting losses. Other highly valued software companies, including ServiceNow Inc. (NOW), Okta Inc. (OKTA), and others have not reached profitability, per Barron's. 

Bullish software analysts are willing to overlook a lack of standard GAAP earnings as they bet on a larger industry shift towards cloud-based subscriptions and away from hardware and on-premise data centers. John DiFucci, a software analyst at Jefferies, for example, says strong recurring revenue makes these stocks attractive. “We are as positive as ever on the business of software,” he says, adding, “However, valuation does give us pause in some instances.”

Looking Ahead

Given these high valuations, investors may need to brace for volatility in these stocks. The iShares Expanded Tech-Software Sector ETF (IGV), for example, has rallied more than 30% this year and has doubled over the past three years. But many individual stocks in the ETF are vulnerable to massive swings based on announcements like a small miss in quarterly earnings. “Software is really risky for investors," says Hickey of the High-Tech Strategist newsletter, who adds, "The risks are not reflected in the stocks.”