What happened
Shares of Unity Software (U 1.08%) plunged 26.5% in January, according to data provided by S&P Global Market Intelligence. To be fair, it wasn't a great month for the broader stock market either, with the S&P 500 down 5% for the month. However, Unity stock fell much further likely due to its lofty valuation. Pricy stocks like this have been selling off particularly hard ever since the Federal Reserve started making policy shifts.
So what
In November 2021, Federal Reserve Chairman Jerome Powell gave a press conference and talked about how the government was tapering asset purchases, something it did to stabilize the stock market at the outset of the COVID-19 pandemic. In December, Powell said there may be interest rate hikes throughout 2022. These decisions have caused stocks with pricy valuations, like Unity, to pull back. For perspective, Unity stock still trades at a price-to-sales (P/S) ratio of around 30 -- you probably couldn't call this stock cheap unless it traded under a P/S ratio of 5 or even lower.
Image source: Getty Images.
Why is Unity stock so pricy? In short, Wall Street analysts and retail investors alike see the long-term potential of the business. For example, BTIG analyst Clark Lampen gave Unity stock a price target of $171 per share on Jan. 10, according to The Fly, calling it a "clear leader" in its 3D content-creation space. Other prominent analysts had similar bullish commentary in January.
Investors are bullish on Unity because 3D content creation is set to grow at a rapid pace in coming years. Some of this growth will likely come from the growing metaverse trend. And in January, this further developed for Unity. Hyundai Motor is building a virtual replica of its manufacturing facility to more easily optimize operations. And in January, it chose Unity as its partner for the project.
Excitement has led to a high stock price. However, a pricy stock does provide Unity with low cost of capital. And the company is leveraging its strong financial position to be the acquirer in its space. Its big splash came in November when it announced it was acquiring Weta Digital for $1.6 billion. However, it made another acquisition in January: Unity acquired Ziva Dynamics, which specializes in ultra-realistic 3D image creation, on Jan. 24 for an undisclosed amount.
Despite these positive developments, Unity underperformed the market in January.
Now what
Fortunately for investors, Unity is off to a better start in February. The stock popped after the company reported financial results for the fourth quarter of 2021 on Feb. 3. Revenue and profits beat expectations and it projects ongoing revenue growth in 2022 to the tune of 34% to 36%.
Longer term, Unity management is still confident it can grow revenue better than 30% annually. And given the tailwinds in its industry, this does indeed seem reasonable. However, it is important to note the company is still projecting an operating loss in 2022 despite its robust top-line growth. For this to be a sustainable long-term investment, Unity management will eventually need to demonstrate operating leverage and grow profits.
