The Nasdaq Composite has been in a bear market since March 2022. Concerns about rising interest rates and other macro headwinds drove investors away from the tech-heavy index of over 3,000 stocks and toward more conservative investments.

The index has made several efforts to recover since that time and nearly reached the cusp of the 20% sustained gain necessary for a new bull market to start. If the bulls eventually do rush back (and they always have before), a lot of battered tech stocks could experience magnificent rallies.

Could Unity Software (U -2.01%), which lost more than 80% of its value since hitting its all-time high on Nov. 18, 2021, be one of those comeback plays? Let's review its business model, its near-term challenges, and its valuations to decide.

A person plays a video game on a desktop PC.

Image source: Getty Images.

What does Unity Software do?

When Unity went public on Sept. 17, 2020, it attracted a lot of attention, for several reasons. Its eponymous game development engine was already used to create more than half of the world's mobile, PC, and console video games. Instead of developing different assets (such as graphics, sound effects, and multiplayer features) separately, developers could use Unity's platform -- which bundled all those tools together -- to quickly create new games.

Unity operated a sticky freemium model. Smaller developers could create their games for free, while paid developers could remove its intrusive splash screen and gain access to more cloud-based diagnostic tools. Unity also provided ad tech tools that enabled developers to monetize their own games with integrated ads. 

Unity's stunning growth rates initially supported the bullish thesis. Its revenue rose 43% in 2020 and grew another 44% to $1.1 billion in 2021. CEO John Riccitiello also repeatedly claimed Unity could grow its annual revenue by "above 30% for the long term" as the gaming market continued to expand. It wasn't profitable on a generally accepted accounting principles (GAAP) basis, but it claimed its free cash flow (FCF) would turn positive by 2023.

Why did Unity's stock crash?

That long-term outlook seemed bright, but Unity tripped over three major hurdles last year. First, the growth of the gaming market cooled off after it lapped its pandemic-era acceleration. That slowdown coincided with intense competition from similar game development engines like Epic Games' Unreal Engine.

Second, the macro headwinds caused many advertisers to reduce their marketing spend, which directly throttled the growth of Unity Ads. Lastly, Apple's privacy-oriented iOS update in late 2021, which allowed its users to opt out of data tracking features, exacerbated that pain. To address Apple's seismic changes, Unity scrapped its entire advertising algorithm and merged with another ad tech company, ironSource, in a $4.4 billion all-stock merger last November.

As a result, Unity's revenue only rose 25% to $1.4 billion in 2022 as its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) loss more than doubled from $20 million to $51 million. But in 2023, Unity expects its revenue to rise 47%-58% (mainly driven by its merger with ironSource) with a positive adjusted EBITDA of $230-$300 million. It also believes it can generate an annual adjusted EBITDA run rate of $1 billion by the end of 2025. For 2024, analysts expect its revenue to rise 18% to $2.5 billion as its adjusted EBITDA more than doubles to $541 million.

That forecast seems promising, but many investors had already been burned after Unity's valuations hit unsustainable levels during the meme and growth stock rally in 2021. At its peak, Unity's enterprise value reached $56.2 billion -- or 40 times the revenue it would generate in 2022. Today it looks much more reasonably valued at just 6 times its estimated revenue in 2023, but investors still don't seem convinced its highly dilutive takeover of ironSource will pay off.

Will Unity's stock recover in a bull market?

If the Nasdaq Composite enters a new bull market, we can assume that more investors are looking past the near-term challenges of inflation and high interest rates while focusing more on the secular growth potential of certain technologies.

Video games and digital ads are two of those technologies. If Unity demonstrates that it's successfully integrating ironSource, overcoming Apple's disruptive platform changes, and converting more of its free users to its paid plans, its stock could certainly soar again. But if it falls short in those three key areas, its stock could slump even if the Nasdaq rallies.