Coming out of a year in which software multiples have been battered by rising interest rates, and actual macro impacts then pressured results, it’s not surprising that investor sentiment is flaccid. The current valuations have already set a new norm with PEG of about 1x, so valuations of some tiny tech firms are attractive now.
40% earnings growth needed to maintain high valuation
Despite valuation headwinds due to higher inflation/rates throughout 2022, we still see software as a highly attractive sector for investors to own, due to its defensive qualities, and more importantly, its exposure to sectoral growth tailwinds. High levels of recurring revenue and profitability (both on gross and operating margins), low capital intensity, and high cash generation (with favorable working capital cycles) are some of the sector's attractions. Beyond this, there is limited exposure to real-world supply chain challenges which continue to pose challenges to other sectors. Their valuations shouldn’t climb up to peak levels (PEG of 1.5x-2x, and PER at 2SD above their means) in the foreseeable future. However, we believe that PEG of 1x and PER at 1SD above their means are still reasonable for stock with earnings growth of more than 40%.