What happened

Shares of enterprise software-as-a-service (SaaS) firms MongoDB (MDB 2.14%), Datadog (DDOG 0.09%), and Twilio (TWLO 1.40%) were up strongly on Monday, rising 4.6%, 4.6%, and 6.1%, respectively, as of 1:45 p.m. ET.

There wasn't much company-specific news today, but each stock appears to be rising on the heels of private equity (PE) firm Thoma Bravo's acquisition of software peer Coupa Software. Some investors may also be looking to bottom-fish in these beaten-down software stocks in the hope inflation may show more concrete signs of meaningfully declining in tomorrow's Consumer Price Index report.

So what

Over the weekend, private equity firm Thoma Bravo agreed to acquire cloud-based business spending and supply chain software firm Coupa Software for $81 per share, or about $8 billion. The buyout price amounts to about 8.4 times next year's sales estimates, and is about 30% above Friday's closing price. Still, the buyout price is a stunning 78% below Coupa's all-time highs reached back in February 2021.

Of note, Thoma Bravo has scooped up a large number of software companies in 2022 as the sector has fallen out of favor, including the formerly public Anaplan, Ping Identity, and several others. It appears as though this large software-focused firm still has faith in the sector, and remains willing to pay high-single-digit or low-double-digit multiples of sales for these players.

Whenever a large "smart money" buyer finds certain types of assets attractive, it's highly likely to spur buying across the same sector in the public markets, and that appears to be happening in the software sector today. Despite today's rise, MongoDB is down 63% from all-time highs, Datadog is down 67%, and Twilio is down a whopping 90%.

Both MongoDB and Datadog have actually continued to post very strong revenue growth in their earnings reports, with MongoDB recently surging after its strong report just last week. And the stock is still down by two-thirds off its highs. That just goes to show one how highly valued these stocks were to begin with, and how hated the software sector is in today's rising-interest rate environment. And if you're a software stock that has either underperformed or hasn't controlled its expense base very well, well, then you'll have performance more along the lines of Twilio.

Still, investors may be looking at many of these beaten-down stocks as acquisition targets, which can lead to big gains in a short amount of time, as seen in Coupa today.

Furthermore, some may believe the high inflation we've seen over the past year may be declining in a significant way. Tomorrow, investors will get the November Consumer Price Index report released by the Bureau of Labor Statistics. This year, that report has been rather important for all stocks, and especially unprofitable growth stocks such as these SaaS names.

That's because these types of stocks have the entirety of their profits years out into the future, making them highly sensitive to long-term interest rates. The higher inflation and interest rates go, the more those future earnings are discounted, and the less they are worth in today's dollars. However, if inflation is coming down, the value of earnings far out into the future would increase, and these stocks could find a floor. For software companies with recurring revenue and strong secular growth, that may even be the case if the economy enters a short-lived recession, as long as interest rates come down.

However, if the inflation report comes in hotter than expected, it's possible the opposite may occur, and these stocks could fall again.

Now what

While private equity buying these cast-off software stocks is encouraging, it doesn't necessarily mean you should buy into the beaten-down software sector as well. After all, private equity firms can use debt to leverage and enhance equity returns, and because a PE firm owns a company, it can force changes, such as cutting staff and other costs. Many think the technology sector, which has had an amazing run over the past decade, has gotten too bloated with more workers than it really needs.

Therefore, if you buy into unprofitable software firms, you need to make sure that the stock in question either has growth prospects strong enough to justify the current price-to-sales ratio, or that the company can self-correct and help itself by cutting out unnecessary expenses. Twilio, which has been one of the most egregious spenders in the space, has made some efforts to cull expenses recently. Last Friday, it decided to end its dual listing on the Long-Term Stock Exchange (LTSE), which incurred an extra expense, while keeping its other remaining listing on the New York Stock Exchange. Still, that's likely to be a mere drop in the bucket for Twilio's expenses, which are still quite high compared with its gross profits.

Thus, investors shouldn't necessarily buy into these stocks on hopes of a buyout, as that may not happen. Meanwhile, there is also the possibility interest rates will remain higher for longer than some think. Despite their large year-to-date declines and private equity interest, SaaS stocks remain a risky bet for public market investors.