By Jacob Sonenshine
Worries about software companies are bringing the issue of true profitability into focus, making good stocks with real earnings look attractive.
The iShares Expanded Tech-Software Sector exchange-traded fund is down 24% from a record high hit in late September. Investors are concerned that many of the companies, especially the smaller ones, will prove obsolete as artificial intelligence becomes able to handle more tasks. And they are worried that earnings from AI for companies such as Microsoft won't be large enough to justify their enormous investment in infrastructure.
A third issue is concern that OpenAI, a critical customer for Oracle, which has a weighting of 7.5% in the ETF, won't have the money it needs to pay for services it has agreed to buy from the company.
All that is why profitability matters now, especially for smaller and midsize names. Many of those companies would flirt with losing money if competition from AI materializes, and a few might ultimately file for bankruptcy.
While Wall Street's estimates for aggregate earnings at companies in the software fund have risen, according to FactSet, that is because the market's doubts go beyond the immediate term.
But analysis by Trivariate Research's Adam Parker shows that historically, when software valuations fall to the degree that they recently have, lower profit forecasts usually follow. That means companies that are reporting relatively large adjusted earnings, as opposed to real earnings, might have a target on their backs from the market's perspective.
Adjusted earnings remove certain expenses. Those can be one-time costs such as restructuring charges that likely won't appear again.
Companies often take stock-based compensation expense out of their financial statements to show an adjusted figure, not in compliance with generally accepted accounting principles, or GAAP. Managements that do that are essentially saying that because they saved cash by issuing stock to pay their staff, shareholders should know how earnings look, reflecting those savings.
While reporting non-GAAP earnings is optional, companies are required to disclose their GAAP results. That figure is usually lower.
A risk is that as these companies grow and generate more cash, they will use more cash to pay employees. That means one day, this cash expense will show up on their income statements as general and administrative expense. And that expense will make today's non-GAAP earnings look artificially high.
That is why Citi analyst Fatima Boolani identified software companies that are trading at prices that look cheap relative to their GAAP earnings, rather than their non-GAAP profits. Given the distortions in non-GAAP earnings, stocks that are trading at fairly low multiples on that basis may not actually be so cheap. The ones trading at cheap multiples of GAAP earnings are safer.
Boolani's list includes ZoomInfo Technologies, at about 14 times expected GAAP earnings for the coming 12 months; Nice Ltd., at 12 times; Salesforce, at 24 times; and Adobe, at 15 times. Those are all providers of programs that help companies work with and analyze their data. The median for that group is about 29 times.
Among providers of software for the back office, there is Dropbox at just under 13, Open Text at just below 11, and Roper Technologies at just under 23. The median for this group is just over 30.
A particularly interesting one is Fortinet, a provider of cybersecurity software. It trades at just under 31 times, versus a median of roughly 38 times for cybersecurity and infrastructure stocks in general. Cyber names like Fortinet seem less vulnerable to the AI threat, given that the big AI names may not compete in that area any time soon.
Stock-based compensation totaled only 4% of its 2025 revenue, versus a group median of 15%. That means the adjusted earnings it has reported are fairly close to its true earnings.
If there are any software names to take a flier on, these are a promising bunch.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
February 03, 2026 13:24 ET (18:24 GMT)
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