Morgan Stanley has reiterated its bullish stance on the North American software sector in its latest valuation review. However, the firm acknowledges that the investment case for software has become increasingly contentious as AI-related capital expenditure winners regain market leadership.

Following a recent market correction, the sector's overall valuation has fallen noticeably below its five-year average. Despite this, the performance bar for high-growth, high-valuation companies remains stringent, and only a select few are positioned to clear it through strong earnings delivery.

Over the past week, software stocks have significantly lagged the broader market. Morgan Stanley's data shows that the median software stock fell 4.1% for the week, while the S&P 500 and Nasdaq dropped 0.8% and 0.7%, respectively. Year-to-date, the median software stock has declined 6.5%, in stark contrast to gains of 13.3% and 11.9% for the Nasdaq and S&P 500. The median software stock is currently trading about 27% below its 52-week high, reflecting a substantial valuation and price adjustment.

The divergence among individual stocks has been particularly sharp. Cloudflare (NET.US) and DigitalOcean (DOCN.US) were top performers last week, jumping 9.9% and 9.3%, respectively. Conversely, ServiceTitan (TTAN.US), Braze (BRZE.US), and Navan (NAVN.US) saw their shares plummet 37.8%, 25.1%, and 24.3% following their earnings reports. This highlights a key market trend: investors are not indiscriminately selling the sector but are applying increasingly rigorous scrutiny to companies' ability to deliver on their financial promises. As of writing, Cloudflare is up over 6% in pre-market trading, while DigitalOcean is down over 3%, ServiceTitan is up over 3%, Braze is up over 4%, and Navan has gained 0.76%.

Software Valuations Cool Broadly, Though Premiums Persist at the Top

From a valuation standpoint, the software sector has undergone a significant compression. Morgan Stanley's data indicates that the companies it tracks trade at approximately 5.9 times forward 12-month EV/NTM Sales, roughly 18% below the five-year average of 7.3 times. When factoring in growth, the sector's EV/NTM Sales relative to its two-year forward revenue growth rate stands at about 0.41 times, also around 15% below the historical average of 0.49 times.

However, this apparent "cheapness" is not uniformly distributed. The five highest-valued software companies in Morgan Stanley's coverage still trade at an average EV/Sales of about 28.1 times, which is roughly 7% above their five-year average of 26.1 times. In other words, while the market has generally lowered software valuations, investors are still willing to pay a significant premium for a select group of high-growth favorites. This implies that these richly valued companies face a higher bar for performance. Simply posting decent growth may no longer be enough; they must deliver stronger results and forward guidance to justify their valuations.

High-Growth Stocks Remain Expensive, Limiting Room for Error

The valuation divergence is more apparent when examining different growth tiers. Morgan Stanley's data shows that software companies with expected revenue compound annual growth rates exceeding 25% currently trade at about 12.9 times forward 12-month sales, only about 1% below the five-year average of 15.8 times. This suggests that true high-growth players, despite the recent pullback, are trading near historical averages without a significant "discount."

Looking closer at specific high-growth names, Morgan Stanley categorizes companies with sales compound growth above 20% into this group. These companies' average share price is about 77% of their 52-week high, with an expected 2025-2027 sales CAGR averaging 31%. Yet, they still command an average EV/Sales multiple of 24.9 times based on 2027 projected sales. This group includes 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 suggests that despite the pullback from highs, investors are still paying a very high price for future growth. Consequently, if companies fail to demonstrate sustained rapid growth in upcoming earnings, valuation compression could quickly morph into significant share price declines. The sharp sell-offs in ServiceTitan, Braze, and Navan after their reports exemplify this high-stakes environment.

Mid-Tier Growth Valuations Remain Above Historical Averages

Notably, mid-tier growth companies have not seen the same valuation discounts. For software companies with revenue CAGRs between 15% and 25%, Morgan Stanley calculates EV/NTM Sales at approximately 8.4 times, slightly higher—about 4%—than the five-year average of 8.1 times. In another classification, mid-tier growth stocks have pulled back to about 71% of their 52-week highs, with an expected two-year sales CAGR of about 17% and an average 2027 EV/Sales of approximately 8.3 times.

For this cohort, a simple fall from peak prices does not automatically equate to a "cheap" valuation. Any share price drawdown must be assessed alongside changes in future growth expectations. If earnings estimates are also being trimmed, the apparent drop in price may not actually create a safety margin for investors.

Low-Growth Software Provides the Most Pronounced Discount

Compared to their high- and mid-growth counterparts, low-growth software companies have experienced the most substantial valuation compression. Morgan Stanley's data reveals that software companies with revenue CAGRs below 15% currently trade at just 3.5 times EV/NTM Sales, which is roughly 28% below the five-year average of 4.9 times and even lower than the 4.5 times average seen between 2014 and 2018.

Another sample of low-growth companies shows their average share price is around 74% of their 52-week high, with an expected two-year revenue CAGR of only about 8%. Their average EV/Sales based on 2027 sales projections is 4.3 times. This group includes 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 confirms that the clearest valuation discounts in the software sector are concentrated in slower-growing, mature companies. However, this presents its own challenge: a low valuation alone is not a catalyst. If these companies cannot re-accelerate their growth, their low multiples could persist. The companies most likely to see significant re-rating are those already priced as low-growth entities but capable of demonstrating a growth resurgence in the future.

Infrastructure and Cybersecurity Maintain a Clear Valuation Premium

Within the software sector, the market's preference for AI infrastructure and cybersecurity remains evident. Morgan Stanley's data shows that infrastructure software currently trades at about 10.1 times EV/NTM Sales, and cybersecurity software at 9.3 times, compared to an overall SaaS average of just 4.4 times. While the valuation gap between cybersecurity and infrastructure has narrowed, both still command a very significant premium over traditional SaaS applications.

This aligns with recent capital flows, as beneficiaries of AI capital expenditure regain market leadership. Traditional application software, meanwhile, faces an ongoing debate over whether AI is a growth catalyst or a potential disruptor. The sector is experiencing a clear "re-rating" where companies more directly tied to AI infrastructure, data traffic, and cybersecurity demand retain higher valuations, while the valuation center for traditional SaaS has shifted downward.

Cash Flow and Profitability Metrics Reveal a Steeper Decline

When valuing the sector on free cash flow and earnings rather than revenue, the picture shows an even more pronounced discount. Morgan Stanley's data indicates the software industry's overall EV/NTM FCF is around 23.2 times, substantially lower—by about 37%—than the five-year average of 37.1 times and about 69% below the historical peak of 75.9 times. For companies with comparable earnings data, the forward P/E is approximately 13.8 times, which is 33% below the five-year average of 20.7 times. On a GAAP basis, the overall software coverage group trades at a forward P/E of about 26.1 times, roughly 14% below the five-year average of 30.5 times. For a set of more mature software companies, the GAAP forward P/E sits at about 21 times, which is 30% lower than the historical average of 30.1 times.

From an earnings and cash flow standpoint, the software sector has experienced a more pronounced valuation normalization than what is reflected in revenue multiples.

Morgan Stanley Stays Positive on Software, But Stock Selection is Paramount

In summary, Morgan Stanley remains positive on the North American software industry, but the current investment landscape differs markedly from the past era of broad-based multiple expansion. On one hand, the sector's overall valuation has dropped below its five-year average, particularly for low-growth firms, free cash flow, and earnings-based metrics, offering a measure of valuation support. On the other hand, the high-growth names favored by the market still carry hefty valuations, necessitating that these companies consistently exceed already elevated expectations.

The extreme stock reactions following recent earnings underscore that the market is quick to punish those who fail to meet high performance standards. The sharp divergences—with ServiceTitan down 37.8%, Braze down 25.1%, and Navan down 24.3%, compared to gains of 9.9% for Cloudflare and 9.3% for DigitalOcean—perfectly illustrate the current selective and demanding market environment.