The important valuation metric fueling the AI software sell-off
Why has the sell-off in software stocks — driven by artificial intelligence disruption fears — been so dramatic and seemingly unending? In this Club Check-in, CNBC’s Paulina Likos and Zev Fima answer that question by diving into an important concept that investors use to evaluate stocks called terminal value. Software profits have not collapsed, and earnings expectations for the next year seem to remain intact. And yet, there’s been carnage across the software complex this year. What has changed is Wall Street’s confidence in how to value these businesses beyond the next few years, due to fears that AI could fundamentally alter their long-term earnings power. In particular, investors are rethinking their assumptions around software companies’ terminal value — essentially the “forever” value of the business. When uncertainty around that assumption is elevated and people are asking existential questions, investors are going to demand lower valuations today before they’re willing to buy shares. That has major ramifications for stock prices, as we’ve seen this year in companies like Salesforce, Workday and ServiceNow. The terminal value may be a new term for some Club members, and understandably so. In day-to-day discussion around the stock market, price-to-earnings multiples get the bulk of the attention as a valuation metric. That makes sense when you’re looking only one to two years into the future, or even more short-term than that. But when you’re looking to value companies over a multiyear period, the gold standard technique is something called a discounted cash flow (DCF) model. That’s where the terminal value comes into the picture. It’s an essential ingredient in those models. As Zev explains in the video, small changes in terminal value assumptions can drive much larger swings in what investors are willing to pay for a stock today than changes to near-term cash flow projections. For investors, understanding this dynamic helps clarify whether the structural risk concerns driving this sell-off are justified, or whether it’s creating selective opportunities in stocks where the long-term fears are overdone. See here for a full list of the stocks in Jim Cramer’s Charitable Trust. As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
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