What happened
Shares of Unity Software (U -1.06%) plunged 74.2% in the first half of 2022, according to data provided by S&P Global Market Intelligence. For its part, the stock market fell over 20% during this time, so it's a harsh market. However, investors were particularly bearish about Unity because of its high valuation and a big problem that it discovered with its business.
So what
Unity's software is often used in mobile gaming. Companies can build their gaming app and run it through the different solutions Unity provides. Building solutions are in Unity's create segment, whereas the company's operate segment records revenue generated from helping run and monetize the applications.
Unity had its initial public offering (IPO) in 2020, which was well received by the market. Investors were excited to own a piece of a company with a leadership position in the digital-content creation space. And with this excitement, Unity stock traded at extremely high valuations.
At its high point late in 2021, Unity had a price-to-sales (P/S) ratio of 55, whereas a cheap P/S ratio is generally considered to be in the single digits. Moreover, its average P/S ratio in 2021 was 34, according to YCharts -- much higher than the average stock.
On March 16, the Federal Reserve started raising interest rates. And in May, it voted to raise rates at its fastest pace in 20 years, with ongoing rate hikes scheduled for the remainder of the year.
When interest rates are low, things like bonds offer investors very poor returns. Consequently, investors pile into stocks and valuations go up. But when rates start going up, low-risk investments become viable again, causing money to flow out of stocks. As a result, valuations come down. And this is what happened with Unity. Its P/S multiple has shrunk from a high of 55 to where it trades today, at around 10.
In other words, Unity's P/S valuation is 80% lower now than what it was at its peak in 2021 -- this explains the drop. However, Unity does have a problem of its own that isn't related to interest rates.
Unity's operate segment helps apps run effective ads. When the company announced financial results for the first quarter of 2022 on May 10, it told investors that its algorithm had been fed bad data, which will cost it $110 million in lost revenue and will take up to two quarters to fix. The stock plunged dramatically as a result.
Now what
Unity stock is a conundrum right now. On one hand, investors should celebrate a cheaper valuation because -- all things being equal -- chances for positive returns are greatly amplified.
However, all things are not equal. Unity must fix its algorithm as quickly as possible to restore confidence from its customers and not permanently lose business to competitors.
If you buy shares today, you should be confident in Unity's ability to fix the problem and not let it happen again. For those who don't have that confidence, it may be best to take the wait-and-see approach, monitoring results in coming quarters.
