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"For the first time, true value stocks have emerged in the software industry."
This is a groundbreaking view recently put forward by analyst Mr. Davidson. Behind this statement lies a paradigm shift in the software industry unseen in two decades.
Looking back over the past two decades, there has been almost only one narrative for software stocks: high growth, high valuation, and high imagination. It was an era when the "Price-to-Dreams" ratio prevailed, and investors frantically chased ARR (Annual Recurring Revenue) growth rates, net expansion rates, and the Rule of 40. In that golden age of SaaS (Software as a Service), as long as a company could maintain a revenue growth rate of 30%–50%, capital markets were willing to grant a P/S (Price-to-Sales) valuation of 10x or even 20x, even if it was mired in deep losses.
Back then, if a software company was labeled a "value stock," it often signaled negative connotations—stagnant growth, aging products, and management failures. It was an "abandoned child" in the eyes of growth investors, synonymous with a lack of imagination.
Today, however, this logic is being completely shattered.
Given the reversal of the global interest rate cycle, the restructuring driven by AI technology, and the maturation of business models, an unprecedented new asset structure has emerged in the software industry: one where companies maintain growth, generate massive profits, and remain undervalued by the market.
Questions naturally follow—when "growth stocks," "GARP (Growth at a Reasonable Price) stocks," and "value stocks" coexist in the software sector, the industry is no longer a single track but has begun to show clear stratification. This, perhaps, is the true signal that the software industry is entering a mature cycle.
The First Emergence of "Value Stocks" in Software: The End of an Era
Over the past two decades, the concept of "value investing" has virtually never existed in the software industry.
Against the backdrop of abundant liquidity, capital was willing to pay a hefty premium for future uncertainties. Software companies generally adopted a model of "high SBC (Stock-Based Compensation) + continuous expansion + long-term losses." Founders and employees got rich through stock options, while companies burned cash in exchange for market share. Under this model, free cash flow was often negative, making talk of "value" seem entirely out of place.
However, as the interest rate cycle reversed in 2022 and the era of cheap money came to an end, this logic was forcibly reset.
Capital markets have begun to re-evaluate the profitability and cash flow quality of software companies. Investors are no longer satisfied with "stories about the future"; they demand to see "cold, hard cash today." The latest research by Davidson's team reveals that a batch of typical "cash machines" has emerged in the software industry, boasting free cash flow yields so high that they have drawn the admiration of traditional industries.
Data shows that Adobe's free cash flow yield, net of SBC, is close to 9%; payment giant Ramp is near 10%; and cloud storage company Box has even reached 19%.
This was almost unimaginable a decade ago. Traditional utility stocks or high-dividend blue-chip stocks typically yield only in the 3%–5% range. When the cash flow yield of software companies reaches double digits, it signifies that they have stepped out of the "venture capital" category and entered the "mature cash flow" stage.
This indicates that the software industry is undergoing a critical turning point: for the first time, it offers room for "value investing" just like traditional industries. Investors can buy software stocks to secure stable cash flow returns, much like purchasing shares in utility companies or banks.
However, this does not mean the software industry as a whole has entered a value cycle. On the contrary, internal divergence within the industry is rapidly widening. Companies unable to generate cash flow and still dependent on financing for survival are being marginalized, while leading companies build deeper moats via strong cash-generation capabilities.
The Software Industry is Splitting into a Three-Tier Structure
Based on current market investment logic, software companies are being reclassified into three types: growth stocks, GARP, and value stocks. This stratification is precisely the process by which capital markets are repricing the software industry, and it is also a hallmark of industry maturity.
The first tier still consists of high-growth software companies.
Companies like Snowflake, Datadog, and Shopify remain in a phase of rapid expansion. Their core logic is "platform-level growth." Snowflake represents data cloud infrastructure, Datadog represents observability platforms, and Shopify is an e-commerce operating system.
These companies continue to maintain growth rates of 20%–30% or even higher. Investors are willing to pay higher valuations for them, essentially betting on their future platform monopoly power. In today's unceasing wave of digitalization, the winner-takes-all effect at the infrastructure layer remains significant. As long as they can prove themselves to be the "water, electricity, and coal" of the next decade, the market is willing to overlook short-term profit fluctuations.
The second tier comprises an increasingly important category of companies—GARP (Growth at a Reasonable Price).
Microsoft, ServiceNow, Dynatrace, and JFrog belong to this category. These companies are no longer early-stage growth stocks, but they still maintain steady growth. Revenue growth rates typically range between 10%–20%, while profit margins continue to improve.
In other words: they are both growth stocks and cash flow machines.
Microsoft is a typical case. In the AI era, Azure cloud services and Copilot are reigniting growth, while Office and Windows provide stable cash flow. This gives Microsoft both a growth premium and value attributes. It no longer needs to sacrifice profits for growth, nor give up growth for profits. This "dual-engine drive" model is the core essence of the GARP strategy.
The third tier, meanwhile, consists of a new species that has just emerged in recent years: software value stocks.
Companies like Box, Progress, and Ramp no longer grow aggressively, but their cash flows are extremely stable. When their free cash flow yields hit the 10%–20% range, these firms start to resemble "software equivalents of utility companies."
This has almost never occurred in the history of the software industry. In the past, software was considered a high-risk asset; now, some software assets possess bond-like stability. Such companies typically hold a monopoly in a specific niche, with extremely high customer stickiness and massive switching costs. Therefore, they can maintain the status quo and generate huge amounts of cash without heavy R&D investments.
However, the formation of this three-tier structure also signifies a more critical change: the software industry has transitioned from a "single growth track" to a mature industry stage. Investors can no longer blindly buy "software ETFs"; instead, they must carefully identify the tier in which a company is positioned, just as they would when selecting consumer or industrial stocks.
The True Watershed: Software Winners in the AI Era
The true divergence in the software industry is not merely a change in growth rates. The real watershed lies in the software capability structure under the AI era.
AI is dividing the software industry into two types of companies: platform software companies and functional software companies.
Platform companies possess ecosystems, data, and infrastructure.
Examples include Microsoft (AI + cloud platform), Snowflake (data platform), and Datadog (monitoring platform). These companies are actually stronger in the AI era because AI requires data, computing power, and platform integration capabilities. Large language models themselves do not generate value; value is generated at the intersection of large models and enterprise data. Platform companies precisely control data entry points and computing power scheduling.
Not only will they not be replaced by AI, but they will also leverage AI to increase average ticket sizes and enhance user stickiness. For instance, Microsoft can embed Copilot into the entire Office suite, directly boosting ARPU (Average Revenue Per User); Snowflake can utilize AI to optimize data query efficiency, consolidating its data cloud position.
The other category, functional software companies, faces the risk of being restructured by AI.
Examples include CRM tools, customer service automation software, and single-function SaaS. Many products are being directly replaced by AI Agents or large model capabilities.
In the past, enterprises needed to purchase dedicated software for customer service ticket management; in the future, an AI Agent might directly read emails, auto-reply, and auto-archive without the need for an independent SaaS interface. Previously, companies had to buy specialized code assistance tools; in the future, this could become a built-in feature of the IDE (Integrated Development Environment).
This is also why the market has begun to lower valuations for some software companies—even if they remain profitable. The market worries that their "functions" will be covered for free by the platform capabilities of tech giants, or face asymmetric disruption from AI-native applications.
From this perspective, the future of the software industry may present a new landscape: a few platform companies will continue to enjoy growth premiums, a batch of mature software companies will transform into cash flow assets, and a large number of functional SaaS will gradually be marginalized, or even reduced to mere plugins for AI large models.
This also implies a complete shift in investment logic.
Past software investments only looked at growth. As long as revenue growth was fast, no problem was a problem. Today's software investments must simultaneously answer three questions: Where does the growth come from? Is it organic growth or built through M&A? Is it a platform effect or a single function? What is the moat? Is it a data barrier or switching costs? Is it still solid in the AI era? Is the cash flow real? Net of SBC, is the company truly making money? Can it withstand the risk of high interest rates?
When growth stocks, GARP, and value stocks begin to emerge simultaneously in the software industry, it is actually no longer an "emerging industry." The characteristics of an emerging industry are homogeneous competition and wild growth, whereas a mature industry is characterized by clear stratification and survival of the fittest.
The software industry is entering a new phase. It is no longer a jungle where only dreamers can survive, but has become a ballast stone that institutional investors can allocate for the long term.
Software, Is Becoming a True "Core Asset Industry"
This means that, for investors, the difficulty of investing in software stocks has increased, but the certainty has also improved. We no longer need to bet on the next unicorn with 100x growth; instead, within the three-tier structure, we can choose high-growth platforms, steady GARP leaders, or high-dividend value stocks based on our own risk preferences.
Software is shedding its illusory bubbles and returning to its commercial essence. It is becoming a true "core asset industry."