MW Software stocks are in bargain territory - and that's reviving an age-old debate
By Christine Ji
Valuations have come way down for software stocks - but just how cheap they really are depends on your view of a sizable hidden expense
Stock-based compensation is a noncash expense that often lurks below the surface when companies present adjusted financial metrics.
For years, fast-growing software stocks commanded lofty valuations. Investors unwilling to pay the price looked for cheap opportunities in sectors like utilities and energy.
Artificial intelligence has flipped the script, turning software stocks cheap and energy stocks expensive. But even with historically low valuations, software companies still need to convince investors that they're reasonably priced.
The AI-driven selloff "has helped bring software valuations to reasonable levels" for the first time in over five years, D.A. Davidson analyst Gil Luria wrote in a note earlier this month. The forward price-to-earnings multiple for the iShares Expanded Tech-Software Sector ETF IGV is currently 22, compared to its five-year average of 34, according to Dow Jones Market Data. Among the index's 118 constituents, 73 are trading at 20% or less away from their five-year lows on the valuation metric.
Luria thinks all that is piquing the curiosity of value investors, who buy stocks they believe are trading at a discount to their intrinsic worth. But it's also thrusting a decades-old accounting debate back into the spotlight. To some investors, software stocks may not be as inexpensive as they look when considering the murkiness of stock-based compensation - a heavy expense that gets stripped from many companies' adjusted earnings metrics.
"All of a sudden, you have these software companies trading at very attractive valuations, at least on a cash-flow basis or an adjusted, non-GAAP basis," Luria told MarketWatch, referring to financial metrics that deviate from Generally Accepted Accounting Principles. "But value investors are wondering if it's really that cheap if you need to exclude stock-based compensation from the calculation."
Read: Can Adobe's next CEO turn around its battered stock?
Accounting for stock-based compensation
It's standard practice for public companies to report both GAAP and non-GAAP earnings. The latter refers to adjusted financial results that remove certain expenses the company deems noncore or noncash, such as stock-based compensation, one-time restructuring costs or the amortization of past acquisitions. Doing so can present a more normalized picture of a company's financial performance.
But critics argue these adjustments can be misleading. One of the biggest opponents is Warren Buffett, who famously asked in his 1998 shareholder letter: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it?"
Stock-based compensation is especially relevant for tech companies that make equity a big component of employee pay, Luria said. If a company promises an engineer $50,000 of stock over five years, GAAP accounting requires the company to record that as an upfront expense.
But high employee turnover in the industry often prevents those shares from vesting, Luria pointed out. "And so, recognizing that $50,000 as a real cash expense in year one makes no sense," he explained. Doing so would penalize some software companies for expenses that may not end up materializing to such an extreme degree, he added.
Still, some tech giants have taken these complaints to heart recently. Nvidia (NVDA) announced on its earnings call last month that it would no longer exclude stock-based compensation from its adjusted operating expenses, starting with the current quarter. That makes Tesla $(TSLA)$ the only remaining "Magnificent Seven" name still adjusting out stock-based compensation.
In the fiscal year ending January, Nvidia added back $6.4 billion of stock-based compensation to its net income of $120.1 billion. The impact is relatively small for Nvidia, but "high-growth, newer public companies and more software companies (over hardware) tend to have a higher percentage of revenue 'spent' on stock-based compensation," Piper Sandler analyst James Fish wrote in a March note. Historically, stock-based compensation exceeding 10% of total revenue is perceived as "elevated," Fish noted.
Within Piper Sandler's coverage of 24 digital infrastructure and connectivity software stocks, Fish flagged SoundHound AI (SOUN), Cloudflare (NET), Rubrik $(RBRK)$, Fastly (FSLY) and Samsara $(IOT)$ as companies with the highest levels of stock-based compensation, or SBC, relative to revenue for calendar year 2025.
Name SBC as % of revenue GAAP net income Non-GAAP net income Share dilution (ex-buybacks)
SoundHound AI 48% -$14.0 million -$53.9 million 7%
Rubrik 26% -$348.8 million -$1.7 million 7%
Cloudflare 21% -$102.3 million $342.9 million 5%
Samsara 20% -$9.1 million $325.9 million 1%
Fastly 19% -$121.7 million $19.7 million 12%
Source: Piper Sandler, FactSet
SoundHound recorded $80.6 million in stock-based compensation in 2025, amounting to almost half of its 2025 full-year revenue of $168.9 million. However, its GAAP net loss of $14.0 million was actually lower than its non-GAAP net loss of $53.9 million, due to the exclusion of a one-time gain related to the fair value of its warrant liabilities.
For Cloudflare, Fastly and Samsara, excluding stock-based compensation allowed them to turn GAAP net losses into adjusted net profits for calendar 2025.
Read: These 4 cybersecurity stocks are Wall Street's favorite AI-proof plays
Share dilution
Increased scrutiny of stock-based compensation typically intensifies as multiples compress and market fears mount, Fish told MarketWatch via email. He pushed back against the idea that a cohort of value investors is driving the current interest. Instead, the combination of declining valuations and increased investor uncertainty has historically signaled a market bottom, according to Fish.
While investors may be tempted to value software stocks based on GAAP earnings to account for stock-based compensation, both Luria and Fish recommended looking at share dilution instead. When new shares are added to compensate employees, that dilutes the ownership stakes of existing shareholders. The median level of dilution across Piper Sandler's digital infrastructure and connectivity basket is 2% - in line with what Morgan Stanley says is a healthy rate in the low single digits for mid- to large-cap companies.
"For some companies, the dilution is very significant over time, and then you need to factor for that," Luria said. "But for most companies, it's actually not that significant, because only a small portion of the shares actually gets to the hands of those employees."
Specifically, investors should pay attention to dilution without accounting for the offsetting impact of share buybacks. Companies that buy their own outstanding shares from the open market can reduce the total supply and increase earnings per share - but it can be difficult to tell if management is buying back stock because executives believe shares are undervalued, or because they're trying to offset the dilutive effects of stock-based compensation.
In recent months, software companies like ServiceNow (NOW) and Shopify (SHOP) have announced major share-buyback programs as they look to boost investor confidence amid the ongoing software selloff.
Read: ServiceNow CEO looks to call a bottom on software stocks with this $3 million move
-Christine Ji
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March 21, 2026 07:30 ET (11:30 GMT)
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