U.S. software stocks surge against the trend; Morgan Stanley: valuations cooling, stock selection more critical.

Morgan Stanley has just released a valuation report on the North American software industry, maintaining a positive view on the sector. However, the bank noted that with AI capex beneficiaries regaining market leadership, the investment logic for the software sector remains highly debated. After recent corrections, the overall valuation of the software industry has fallen significantly below its five-year average, but the earnings bar for high-growth, high-valuation companies remains very high, and companies that can truly clear that bar through earnings delivery are still limited. Over the past week, software stocks significantly underperformed the broader market. According to Morgan Stanley data, the median software stock fell 4.1% for the week, while the S&P 500 and Nasdaq declined 0.8% and 0.7%, respectively, over the same period. Year to date, the median software stock has fallen 6.5%, while the Nasdaq and S&P 500 have gained 13.3% and 11.9%, respectively, over the same period. The median software stock is currently about 27% below its 52-week high, indicating that the sector has undergone a fairly pronounced valuation and share price correction. Dispersion among individual stocks has been especially severe. Cloudflare (NET.US) and DigitalOcean (DOCN.US) rose 9.9% and 9.3%, respectively, last week, making them the main outperformers. Meanwhile, ServiceTitan (TTAN.US), Braze (BRZE.US), and Navan (NAVN.US) plunged 37.8%, 25.1%, and 24.3%, respectively, after reporting earnings. This also reflects an important feature of the current software stock market: investors are not simply selling the entire sector, but are applying increasingly strict screening on earnings delivery capability. As of press time, Cloudflare extended its gains with the stock up over 6%, DigitalOcean fell over 3%, ServiceTitan rose over 3%, Braze rose over 4%, and Navan rose 0.76%. Software stock valuations cool overall, but top companies still command high valuations From a valuation perspective, the software industry as a whole has already undergone significant compression. According to Morgan Stanley data, the software companies it covers currently trade at an aggregate EV/NTM Sales of about 5.9x, roughly 18% below the five-year average of 7.3x. If growth is further taken into account, the software sector's current ratio of EV/NTM Sales to the next two years' revenue growth is about 0.41x, also roughly 15% below the five-year average of 0.49x. But the problem is that this "cheapness" is not evenly distributed across all software companies. The average EV/Sales of the five most highly valued software companies tracked by Morgan Stanley still stands at about 28.1x, roughly 7% above the five-year average of 26.1x. In other words, although the market has broadly lowered software stock valuations, investors are still willing to pay a clear valuation premium for a small number of the most sought-after high-growth companies. This means that for software companies currently trading at high valuations, the market's requirements for earnings delivery have risen accordingly. Merely achieving decent growth may no longer be enough to drive share prices higher; companies need to demonstrate stronger results and forward guidance to justify their high valuations. High-growth software stocks still expensive, limited margin for earnings disappointment Across different growth tiers, this valuation divergence is even more pronounced. According to Morgan Stanley data, software companies expected to have a revenue CAGR above 25% currently trade at an aggregate EV/NTM Sales of about 12.9x, only about 1% below the five-year average of 15.8x. This means that although truly high-growth software companies have undergone corrections, their overall valuations are in fact still close to historical averages, with no particularly obvious "discount." Looking further at specific high-growth companies, Morgan Stanley groups companies with a sales CAGR above 20% into the high-growth cohort. The average share price of this group is about 77% of its 52-week high, with projected sales CAGR from 2025 to 2027 averaging 31%, yet the corresponding average EV/Sales on 2027 estimated sales is still as high as 24.9x. This includes companies such as 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 pulled back from their highs, investors are in fact still paying very high prices for future growth. Therefore, once financial reports fail to continue proving the sustainability of high-speed growth, valuation compression could quickly sharp share price corrections. The sharp declines in ServiceTitan, Braze, and Navan after their earnings reports are precisely a reflection of the current environment of high earnings thresholds. Mid-growth software stock valuations still above historical averages It is worth noting that valuations for mid-growth companies have not shown an obvious discount. For software companies with a revenue CAGR between 15% and 25%, Morgan Stanley estimates their EV/NTM Sales at about 8.4x, slightly above the five-year average of 8.1x by about 4%. Under another classification method, the average share price of mid-growth software companies tracked by Morgan Stanley has already fallen to about 71% of its 52-week high, with projected sales CAGR of about 17% over the next two years and average 2027 estimated EV/Sales of about 8.3x. Therefore, for this group of companies, the conclusion that "valuations are cheap" cannot be drawn simply because share prices have fallen from highs. Share price pullbacks need to be viewed in conjunction with changes in future growth expectations. If earnings expectations decline in tandem, then the apparent decline may not truly create a valuation margin of safety. The real large valuation discounts are in low-growth software stocks Compared with high-growth and mid-growth companies, valuation compression is most pronounced among low-growth software companies. According to Morgan Stanley data, software companies with a revenue CAGR below 15% currently trade at an EV/NTM Sales of only about 3.5x, roughly 28% below the five-year average of 4.9x, and even below the average valuation of 4.5x from 2014 to 2018. Another sample of low-growth companies in the report shows that the average share price of these companies is about 74% of its 52-week high, with projected revenue CAGR of only about 8% over the next two years, corresponding to an average EV/Sales of about 4.3x on 2027 sales. 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 indicates that the most obvious valuation discounts in the current software sector are mainly concentrated in slower-growing mature companies. But this also raises a question: low valuations alone do not equal catalysts. If these companies cannot reaccelerate growth, then low valuations may persist for a long time. The companies truly capable of generating greater re-rating potential are more likely to be those already priced by the market as low-growth companies but which can subsequently prove that growth is reaccelerating. Infrastructure and cybersecurity still enjoy clear valuation premiums Within different software sub-sectors, the market's preference for AI infrastructure and cybersecurity remains very evident. According to Morgan Stanley data, infrastructure software currently trades at an EV/NTM Sales of about 10.1x, cybersecurity software at about 9.3x, while SaaS companies overall trade at only about 4.4x. The valuation gap between cybersecurity and infrastructure has narrowed, but both still command a very clear premium relative to traditional SaaS. This echoes recent market capital flows. AI capex-related beneficiaries have once again become market leaders, while traditional application software still faces debate over whether AI is a growth catalyst or a potential disruptive force. A clear "repricing" is currently taking place within the software sector: companies more directly tied to AI infrastructure, data traffic, and cybersecurity demand can still command higher valuations, while the valuation center for traditional SaaS companies has clearly shifted lower. Cash flow and earnings metrics show software stock valuations have fallen sharply If valuation is based not on revenue but on free cash flow and earnings metrics, the current discount in the software sector is in fact even more pronounced. According to Morgan Stanley data, the software industry overall trades at an EV/NTM FCF of about 23.2x, roughly 37% below the five-year average of 37.1x, and about 69% below the historical peak of 75.9x. Among selected software companies with comparable earnings data, the forward P/E is about 13.8x, roughly 33% below the five-year average of 20.7x. On a GAAP basis, the forward P/E of the overall software coverage is about 26.1x, roughly 14% below the five-year average of 30.5x. For a group of more mature software companies, the GAAP forward P/E is about 21x, roughly 30% below the five-year average of 30.1x. Measured by earnings and cash flow, the software sector has undergone a more pronounced valuation normalization than revenue multiples suggest. Morgan Stanley remains bullish on software, but stock selection is becoming more important Overall, Morgan Stanley remains positive on the North American software industry, but the current investment environment is clearly different from the past phase when valuation expansion drove the entire sector higher. On the one hand, overall software industry valuations have fallen below the five-year average, especially with low-growth companies, free cash flow valuations, and earnings valuations showing sizable discounts, providing some valuation support for the sector. On the other hand, the valuations of the high-growth companies that are truly favored by the market remain elevated, meaning these companies must continue to deliver results exceeding already high market expectations. The extreme share price reactions after recent earnings reports also show that the market is rapidly punishing companies that fail to meet high earnings thresholds. ServiceTitan plunged 37.8% in a week, Braze fell 25.1%, and Navan dropped 24.3%, in sharp contrast to Cloudflare's 9.9% gain and DigitalOcean's 9.3% gain.