Unity Software (NYSE:U), which develops the Unity Engine for video games and other applications, went public in September at $52 per share. It raised over $1.3 billion in its debut, and its stock subsequently surged to nearly $170 in early December before pulling back to the mid-$140s, which gives it a market cap of nearly $40 billion.

Unity clearly generated some big gains for investors over the past three months, but can it generate more millionaire-making returns in the future? Let's dig deeper into its core business and valuations to find out.

A developer creates a 3D model on a PC.

Image source: Getty Images.

How does Unity make money?

Unity launched its first game development platform in 2004, which bundled together cross-platform rendering, lighting, physics, sound, animation, and user interface tools. In the past, developers created those features individually for different platforms, which was often a buggy, expensive, and time-consuming process.

Unity now serves over 1.5 million monthly active creators, and over half of all mobile, PC, and console games are built with its tools. In 2019, an average of 3 billion apps built with Unity were downloaded each month. Games like Super Mario Run, Among Us, and Monument Valley were all built with Unity.

Unity operates two main platforms: Create Solutions, which includes its development tools for 2D and 3D applications; and Operate Solutions, which adds tools for in-app ads, in-app purchases, analytics, and support for multiplayer games and in-game communications.

The Create business generates revenue from subscriptions and professional services, while the Operate business makes money from revenue and usage-based sharing agreements. It also generates a small percentage of its revenue from strategic partnerships with various hardware and software partners.

Unity still generates most of its revenue from traditional gaming companies, but it's gradually expanding into other markets, including augmented reality, virtual reality, and industrial 3D design.

How fast is Unity growing?

Unity's revenue rose 42% last year, and grew another 44% year over year to $552 million in the first nine months of 2020. It expects its revenue to rise 39%-40% for the full year.

Unity ended the third quarter with a net expansion rate of 144%, up from 132% in the prior-year quarter. This means it generated 44% more revenue from its existing customers -- which indicates its sticky ecosystem is fertile ground for cross-selling new tools and services.

A young woman plays a video game on a PC.

Image source: Getty Images.

About three-quarters of Unity's revenue comes from larger customers that generated over $100,000 in revenue over the past 12 months. Its total number of customers in that tier rose 34% year over year to 739 during the quarter.

During last quarter's conference call, CFO Kim Jabal attributed "some" of its expansion in 2020 to "COVID tailwinds in the Operate business" (from people staying at home and playing more games), and that growth could "result in a tough comparison in 2021."

Unity didn't provide any guidance for 2021, but analysts expect its revenue to rise 26% to $957 million next year. Based on those forecasts, Unity's stock looks pricey at over 50 times this year's sales and more than 40 times next year's sales.

How profitable is Unity?

Unity's top-line growth is impressive, but its net loss widened from $132 million to $163 million last year, and widened again year over year from $113 million to $199 million in the first nine months of 2020.

On a non-GAAP basis, which excludes stock-based compensation and other variable expenses, its net loss narrowed from $35 million to $13 million. On that basis, Unity expects to post a net loss of $66 million to $71 million for the full year.

Unity's adjusted gross margin dipped year over year during the third quarter, due to a higher mix of lower-margin professional services, higher hosting costs for its Operate Solutions, and its takeover of the AR/VR studio Finger Food in April. Analysts expect Unity's non-GAAP net losses to narrow slightly over the next two years, but it won't generate a profit anytime soon.

What are the main headwinds?

Unity is generating robust sales growth from its sticky customer base, but it isn't the only game development platform in town. Epic Games' Unreal Engine -- which powers hit games like Fortnite, PUBG, and Borderlands -- competes against Unity across all the main gaming platforms.

Epic is currently waiving its royalties for Unreal Engine games on its Epic Games Store until they generate $1 million in gross revenue. That lucrative offer could pull developers away from Unity and throttle its ability to raise prices and narrow its losses in the future. Epic is privately held, but its support from Chinese tech giant Tencent (OTC:TCEHY) -- which owns a 40% stake -- could cause headaches for Unity.

Another looming challenge is Apple's (NASDAQ:AAPL) iOS 14 update, which will require apps to request permission to collect data for targeted ads next year. Jabal admitted the update, which would impact its Operate Solutions business, was already causing "uncertainty" for game developers last quarter.

It's too expensive to be a millionaire-maker stock

Unity produces an essential service for many game makers, but its stock is too richly valued to be considered a millionaire-making stock. Its high valuation will require it to retain its current levels of growth for years -- which could be challenging as it faces tougher competition and new data-gathering rules.