Why Most Value Investors Get Tech Wrong - And How to Fix It  ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌

March 02, 2026   |   Read Online The Value Investor's Guide to Software and Tech Stocks Why Most Value Investors Get Tech Wrong - And How to Fix It In partnership with There's a persistent myth in investing circles that "value investing" and "technology stocks" are fundamentally incompatible. That value investors should stick to industrials, banks, and consumer staples - leaving the high-flying tech n ames to growth investors and momentum traders. This is wrong. Not just a little wrong. Profoundly wrong. Warren Buffett bought Apple. Seth Klarman has held tech positions for years. Howard Marks has written extensively about how value and growth are joined at the hip. The truth is that value investing is not about buying cheap companies. It's about buying companies for less than they're worth. And there is no law of finance that says a software company can't be mispriced. But here's the catch: valuing software and technology companies is genuinely harder than valuing a railroad or a cereal brand. The business models are different. The accounting is misleading. The competitive dynamics are unfamiliar. And the margin of safety you need looks nothing like what Benjamin Graham described in 1949. This post is a comprehensive guide to finding, evaluating, and valuing software and technology stocks through the lens of a value investor. Not a growth-at-any-price speculator. Not a momentum trader chasing ARR growth. A disciplined investor who wants to buy wonderful businesses at sensible prices. Let's get into it. Become An AI Expert In Just 5 Minutes If you're a decision maker at your company, you need to be on the bleeding edge of, well, everything. But before you go signing up for seminars, conferences, lunch 'n learns, and all that jazz, just know there's a far better (and simpler) way: Subscribing to The Deep View. This daily newsletter condenses everything you need to know about the latest and greatest AI developments into a 5-minute read. Squeeze it into your morning coffee break and before you know it, you'll be an expert too. Subscribe right here. It's totally free, wildly informative, and trusted by 600,000+ readers at Google, Meta, Microsoft, and beyond. Part 1: Reframing What "Value" Means in Technology The Old Framework Doesn't Work (Directly) Traditional value investing gives you a toolkit: low price-to-earnings ratios, low price-to-book, high dividend yields, assets trading below liquidation value. These metrics were designed for asset-heavy businesses - manufacturers, real estate companies, banks. Software companies break all of these heuristics. A great SaaS company might have a P/E of 60, a price-to-book that's technically infinite (because the book value is near zero or negative), and it has never paid a dividend. By every traditional screen, it looks like a screaming sell. But that SaaS company might also have 95% gross margins, 130% net dollar retention, $500 million in annual recurring revenue growing at 30% per year, and a switching cost so high that customers effectively never leave. That business might actually be cheap at a P/E of 60. The key insight: in technology, value lives in the cash flows, not the assets. Your job as a value investor is to figure out what a company's future free cash flow stream is worth today, and then buy it at a discount to that number. The intellectual framework is identical to traditional value investing. The inputs are just different. The Only Number That Matters: Intrinsic Value Intrinsic value is the present value of all future free cash flows a business will generate. This is true for a railroad and it's true for a cloud software company. The difference is that software companies tend to have highly variable outcomes - a wider range of possible futures - which makes the estimation harder and the margin of safety requirement larger. This is actually fine. It just means you need to be more disciplined, not less. Part 2: What Makes a Great Software Business Before you can value a software company, you need to understand what makes one worth owning in the first place. Not all tech companies are created equal. The best software businesses share a set of structural characteristics that make them compounding machines. Recurring Revenue The single most important attribute of a valuable software business is recurring revenue. A company that sells one-time licenses is fundamentally less valuable than one that sells subscriptions. Why? Because recurring revenue is predictable, stackable, and creates a growing base that compounds over time. Look for companies where the vast majority of revenue - ideally 80% or more - comes from subscriptions or contracts that renew annually or monthly. This is the foundation everything else is built on. High Gross Margins Great software companies typically have gross margins between 70% and 90%. This is not a nice-to-have. Gross margin is the ceiling on long-term profitability and free cash flow generation. A software company with 60% gross margins is probably not a pure software business - it likely has a significant services or hardware component that drags on economics. When evaluating gross margins, make sure you're looking at the right number. Some companies report "subscription gross margin" separately from total gross margin. The total number is what matters for your model, but the subscription margin tells you about the underlying quality of the software business. Net Dollar Retention (NDR) This is arguably the single most important metric in SaaS investing. Net dollar retention measures how much revenue you generate from last year's customers this year, including upgrades, downgrades, and churn. An NDR above 100% means the company is growing revenue from its existing base without acquiring a single new customer. Here's how to think about NDR thresholds: Above 130%: Exceptional. The company has massive expansion built into its base. This is common in usage-based models where customers naturally consume more over time. 110% to 130%: Excellent. Strong upsell motion and low churn. This is the sweet spot for most great SaaS businesses. 100% to 110%: Good but not great. The company is retaining its base but not expanding meaningfully within it. Could be fine for a mature business. Below 100%: A leaky bucket. The company is losing revenue from existing customers faster than it can expand them. This is a red flag unless there's a clear, credible turnaround story. NDR above 120% is one of the most powerful forces in business. It means the company has a built-in growth engine that works independently of its sales and marketing spend. Switching Costs and Customer Lock-In The best software companies become deeply embedded in their customers' workflows. When a hospital runs its entire operation on Epic Systems, it's not switching to a competitor because of a 10% price difference. When a company builds its entire data infrastructure on Snowflake, migrating away would cost millions and take years. Look for signals of deep integration: How long does implementation take? How many users within each customer organization use the product? Is the data stored in the platform hard to extract? Does the product integrate with dozens of other tools in the customer's stack? These are all sources of switching cost. Operating Leverage Software businesses have a beautiful economic property: once you've built the product, the marginal cost of serving each additional customer is close to zero. This means that as revenue grows, operating expenses should grow more slowly - creating expanding margins over time. Look for companies that are demonstrating operating leverage, even if they're not yet profitable. The question to ask is: "Is this company's cost structure scaling more slowly than its revenue?" If yes, profits will eventually materialize. If the company is growing expenses as fast as revenue, that's a warning sign. The Rule of 40 A common (and useful) heuristic for evaluating SaaS companies is the Rule of 40: a company's revenue growth rate plus its free cash flow margin should equal or exceed 40%. A company growing at 30% with 10% FCF margins passes. A company growing at 15% with 10% margins doesn't. This is a rough filter, not a precise valuation tool. But it's extremely useful for quickly separating the strong from the weak across a portfolio of potential investments. Part 3: How to Find Undervalued Software Stocks Value opportunities in tech don't look like traditional value opportunities. You won't find them by screening for low P/E ratios. Here's where to actually look. 1. Post-Earnings Overreactions The market routinely punishes software companies by 15-30% for missing revenue estimates by 1-2% or guiding slightly below expectations. These selloffs are often wildly disproportionate to the actual deterioration in the business. A company that was worth $20 billion on Monday is not worth $15 billion on Tuesday because it grew 27% instead of 29%. After every earnings season, build a watchlist of high-quality software companies that dropped 15% or more. Then ask: "Did anything structurally change about this business?" If the answer is no - if the product is still excellent, the customers are still locked in, and the competitive position is intact - you may have found a value opportunity. 2. Sector-Wide Selloffs Periodically, the entire software sector sells off due to macroeconomic fears (rising interest rates, recession concerns) or a narrative shift ("AI will disrupt all existing software"). These selloffs are your best friend as a value investor because they create opportunities to buy the best businesses in the world at meaningful discounts. The 2022 tech selloff was a generational buying opportunity for patient investors. Companies like CrowdStrike, Datadog, and Cloudflare traded at multi-year lows not because their businesses were impaired, but because the market was re-rating all long-duration assets downward. Investors who bought during that window and held have done extremely well. 3. The "Boring" Tech Companies Some of the best values in technology are companies that don't get a lot of attention on social media or from sell-side analysts. Enterprise infrastructure software, compliance tools, vertical SaaS companies serving niche industries - these businesses often fly under the radar because they're not sexy. Look at companies serving industries like insurance, logistics, construction, healthcare administration, or government. These markets are enormous, underdigitized, and have high switching costs. The companies serving them often trade at meaningful discounts to their more glamorous peers despite having equivalent or superior business quality. 4. Transition Periods Some of the best value investments in software happen during business model transitions. When a company moves from on-premise to cloud, from perpetual licenses to subscriptions, or from one-time sales to recurring revenue, the transition creates a temporary depression in reported financials. Revenue may appear to decelerate. Earnings may turn negative. The stock usually craters. But if the underlying business is healthy and the transition is strategically sound, this is often the best time to buy. You're getting the future business model - which is higher quality - at a price that reflects the current messy transition. 5. Insider Buying When executives and board members buy stock on the open market (not through grants or options), pay attention. These people have the best information about the company's prospects. Insider buying at software companies is relatively rare, which makes it all the more meaningful when it happens. Track Form 4 filings. Look for cluster buying (multiple insiders buying around the same time) and purchases that are large relative to the insider's compensation. A CEO buying $5 million of stock in the open market is a much stronger signal than a director buying $50,000. Part 4: Valuation - The Hard Part Now we get to the mechanics. How do you actually put a number on what a software company is worth? Discounted Cash Flow (DCF): The Gold Standard A properly built DCF is the most intellectually honest way to value any business, including software companies. The challenge is that DCFs require you to make assumptions about the future - and with technology companies, the range of possible futures is wide. Here's how to build a DCF for a software company: Step 1: Project Revenue. Start with current ARR (Annual Recurring Revenue). Model revenue growth by separately forecasting new customer acquisition, expansion within existing customers (using NDR as a guide), and churn. Be conservative. Software growth rates almost always decelerate over time as the base gets larger. Step 2: Model the Path to Mature Margins. Most high-growth software companies are not yet at their terminal profitability. You need to estimate what their margins will look like at maturity. The best framework is to look at mature software businesses and use them as benchmarks. Companies like Adobe, Intuit, and Veeva Systems give you a sense of what best-in-class mature SaaS margins look like: typically 30-40% free cash flow margins. Step 3: Discount Back. Use a discount rate that reflects the risk. For large, established software companies, 10-12% is reasonable. For smaller, higher-risk names, use 12-15% or higher. The discount rate is where your margin of safety lives - be honest about the uncertainty and price it in. Step 4: Run Multiple Scenarios. Never rely on a single DCF output. Build a bull case, a base case, and a bear case. Weight them by probability. If the weighted average intrinsic value is significantly above the current stock price, you have a potential investment. Revenue Multiples: A Shortcut (Use Carefully) In practice, most software investors use revenue multiples as a primary valuation tool. This is because many software companies are not yet profitable, making earnings-based multiples meaningless. The key is to use revenue multiples intelligently, not lazily. A 10x revenue multiple means completely different things for two companies with different growth rates, margins, and competitive positions. Here's a framework for thinking about what multiple a software company "deserves": Growth rate is the single biggest driver. A company growing ARR at 40% will command a much higher multiple than one growing at 15%. Empirically, every 5 percentage points of growth is worth roughly 1-2 additional turns of revenue multiple. Gross margin matters enormously. A dollar of 85% gross margin revenue is worth far more than a dollar of 65% gross margin revenue. Adjust for this. Net dollar retention above 120% justifies a premium. This growth is "free" - it doesn't require sales and marketing spend to generate. Free cash flow margin signals maturity and discipline. A profitable company trading at 12x revenue is a very different proposition than an unprofitable company at the same multiple. Market position creates a qualitative premium. Category leaders with dominant market share deserve higher multiples than also-rans. As a rough guide for high-quality SaaS companies in a normal interest rate environment: 30%+ growth, 120%+ NDR, category leader: 10-20x forward revenue 20-30% growth, strong metrics: 6-12x forward revenue 10-20% growth, mature, profitable: 4-8x forward revenue Below 10% growth: 2-5x forward revenue These ranges are wide because every company is different. The point is to have an anchoring framework so you're not just guessing. Free Cash Flow Yield: The Value Investor's Favorite For profitable software companies, free cash flow yield (FCF/market cap) is perhaps the most useful single number. It tells you what return you'd earn if the company distributed all its free cash flow and never grew again. A software company with a 5% free cash flow yield that's still growing at 15-20% per year is an exceptional value. You're getting a growing stream of cash at an already-attractive yield. That's the dream. Conversely, a software company with a 1% FCF yield growing at 10% is probably fairly valued or overvalued. The math just doesn't work unless growth reaccelerates. Part 5: Red Flags - What to Avoid Value investing is as much about avoiding losers as finding winners. Here are the red flags that should make you think twice about a software investment. Declining Net Dollar Retention If NDR is trending down over multiple quarters, the product may be losing its stickiness. This is the single most important trend to monitor in any SaaS investment. A one-quarter dip is noise. Three consecutive quarters of decline is a pattern that demands explanation. Stock-Based Compensation (SBC) Abuse This is the hidden tax in software investing. Many software companies report impressive "adjusted" earnings by excluding stock-based compensation. But SBC is a real cost - it dilutes you, the shareholder, just as surely as if the company had paid cash and issued stock to fund it. Compare SBC as a percentage of revenue across peers. Anything above 25% of revenue is excessive. The best operators keep SBC below 15% of revenue. And always look at GAAP earnings in addition to adjusted numbers. If a company is "profitable" on an adjusted basis but deeply unprofitable on a GAAP basis, the gap is almost entirely SBC - and that's your money. Customer Concentration If a software company derives more than 10% of its revenue from a single customer, that's a risk. If it derives more than 20% from a single customer, it's a serious risk. One contract loss could materially impair the business. Acquisition-Driven Growth Organic growth is worth far more than acquisition-driven growth. When a software company is growing primarily through M&A, look very carefully at how those acquisitions are performing. Are they being integrated successfully? Is the company paying reasonable prices? Or is it using its inflated stock as currency to buy revenue growth it can't generate organically? Serial acquirers in software can be value traps. The reported revenue growth looks good, but the underlying business quality may be deteriorating. Management Selling Aggressively When insiders are buying, pay attention. When they're selling aggressively - especially if multiple executives are selling simultaneously - pay even closer attention. Regular, planned sales (10b5-1 plans) are normal. Large, discretionary sales at or near all-time highs are a warning. Decelerating Growth Without Margin Expansion A software company can slow its growth if it's simultaneously expanding margins. That's a natural maturation. But a company that's both decelerating growth and not expanding margins is in trouble. It suggests the company is still spending aggressively but getting less return on that spending. This is the worst combination. Part 6: The Checklist Before making any investment in a software or technology stock, run through this checklist: Business Quality: Is 80%+ of revenue recurring? Are gross margins above 70%? Is net dollar retention above 110%? Does the company have meaningful switching costs? Is it the leader (or a strong #2) in its category? Is the total addressable market large enough to support years of growth? Financial Health: Is the company free cash flow positive (or on a clear path to profitability)? Is stock-based compensation below 20% of revenue? Does the balance sheet have more cash than debt? Is the company self-funding or does it need to raise capital? Valuation: Is the stock trading below your estimate of intrinsic value? Does your DCF show upside even in the bear case? Is the free cash flow yield (or projected FCF yield in 3-5 years) attractive? Are you getting a margin of safety of at least 25-30%? Qualitative Factors: Is the management team aligned with shareholders (significant insider ownership)? Does the company have a clear, articulate strategy? Is the competitive moat widening or narrowing? Are there any structural tailwinds (regulatory changes, digital transformation trends, platform shifts)? Part 7: Building Your Process Start With Quality, Then Wait for Price The biggest mistake you can make is to start with valuation and work backward to quality. "This stock is cheap" is never a sufficient reason to buy. Instead, build a watchlist of 20-30 high-quality software companies that you've researched thoroughly. Understand their businesses, their competitive positions, their management teams. Then wait. Wait for earnings misses. Wait for sector selloffs. Wait for transitions. Wait for the market to give you a price that makes sense. This is the hardest part of value investing - the waiting. But it's where the returns come from. Size Positions by Conviction Not all ideas deserve equal weighting. Your best ideas - the ones where you have the deepest understanding and the widest margin of safety - deserve larger positions. A concentrated portfolio of 10-15 high-conviction software investments will almost certainly outperform a diversified basket of 40+ names you barely understand. Revisit Your Thesis Every Quarter After every earnings report, revisit your investment thesis. Not the stock price - the thesis. Ask: "Are the reasons I bought this stock still intact?" If yes, hold (or buy more if the price has come in). If no, sell - regardless of whether you're up or down. Think in Years, Not Quarters Software companies compound over long periods. The best investments in this space are the ones you hold for five, seven, ten years. The quarterly noise - the earnings beats and misses, the analyst upgrades and downgrades, the macro fears - are just that: noise. If you've done your work and bought a great business at a fair price, time is your greatest ally. Conclusion: The Value Investor's Edge in Tech Here's the paradox: most professional tech investors don't think like value investors. They think about growth rates, narrative momentum, and relative multiple expansion. This creates a structural advantage for anyone willing to do the hard work of fundamental valuation. When the momentum crowd is chasing the hottest AI stock to 80x revenue, you can be patiently picking up wonderful businesses at sensible prices. When the market has a panic and sells everything with a .com domain, you can be buying with both hands because you've already done the work. Software and technology businesses are, in many ways, the best businesses ever created. High margins, recurring revenues, massive switching costs, operating leverage, and huge addressable markets. The value investor's job is simply to buy them at the right price. That takes patience, discipline, and a willingness to do the work. But the rewards - for those who get it right - are extraordinary. Disclaimer: This post is for educational and informational purposes only. It does not constitute financial advice. Always do your own research and consider consulting with a financial professional before making investment decisions. The author may hold positions in companies mentioned or alluded to in this article.   Update your email preferences or unsubscribe here © 2026 AI Stock Letter 228 Park Ave S, #29976, New York, New York 10003, United States Powered by beehiiv Terms of Service