In March, a bipartisan group of U.S. senators introduced a bill called the Restricting the Emergence of Security Threats that Risk Information and Communications Technology (Restrict) Act. If enacted, it could pave the way to ban popular social platform TikTok across the country.

The bill has yet to be brought to a vote. However, President Biden's White House has already endorsed it, giving some optimism that the bill will gain traction. But banning TikTok, owned by Chinese company ByteDance, could contribute to heightened tensions between the U.S. and China. Those tensions aren't good for the companies looking to China for growth. And real-time 3D software company Unity Technologies (U 1.36%) is one that needs China more than investors realize.

Why the 'TikTok ban' could be big for investors

First, let's acknowledge the following: I'm not here to offer commentary on whether the Restrict Act would be an overreach of power. I'm not a political analyst. Moreover, there's nothing in the Restrict Act that directly relates to Unity.

However, the potential impact of the Restrict Act is still important to consider because it labels the People's Republic of China as a foreign adversary of the U.S. -- that's a macro-economic issue worthy of investors' attention. It's reflective of how tensions between our two countries have escalated in recent years.

Trade tensions are making it harder for U.S companies doing business in China. And it's entirely possible that the Restrict Act could up the ante once more, causing retaliatory measures from China in the future.

When it comes to how this might affect Unity in particular, China is a huge market opportunity for the company, as it offers one of the leading development platforms for videogames, of which China is a major audience. It's impossible to know what retaliatory measures from China would look like, but that's precisely my point. There's plenty of uncertainty when it comes to U.S. companies doing business in China. And this uncertainty will be present as long as tensions are rising as they are right now. 

Why China is important for Unity Technologies

In 2022, only 13% of Unity's revenue came from China. Therefore, investors may underestimate the prominent place China occupies in Unity's growth plans. Indeed, it might not even be fully understood by professional analysts.

For example, in the conference call to discuss financial results for the fourth quarter of 2022, Citigroup analyst Jason Bazinet asked about U.S. tensions with China before nonchalantly saying: "I know China isn't the biggest business geographically for you." But Unity CEO John Riccitiello gently pushed back against downplaying China's importance to the company. "China is the biggest gaming market in the world," Riccitiello said. And the importance of that statement shouldn't be overlooked.

Unity is a 3D software company that video game developers use to create games with high-quality graphics. However, developers don't just use Unity's software to build games; they also use it to publish games, get them discovered, and monetize them through ads. Therefore, Unity generates revenue when games are built and can keep generating revenue throughout the entire life of the game as well.

Unity doesn't specify exactly how much of its revenue comes from the video game market -- it has applications beyond the gaming space. But it's safe to say it's the majority of the company's income. For evidence, consider that Unity lists video game companies as its top competitors. Moreover, management repeatedly talks about its market-leading position in the gaming space. An explicit component of its growth strategy is expanding beyond the gaming market -- implying that the gaming market is its bread and butter.

Two children looking at smartphones.

Image source: Getty Images.

Therefore, gaming is huge for Unity. And as Riccitiello points out, China is huge for gaming. According to video game research company Newzoo, there are 744 million gamers in China alone. The next closest country is the U.S. with roughly 210 million. In other words, China has 3.5 times as many gamers as the U.S.

From a revenue perspective, the same Newzoo report found China and the U.S. are about equal. But this still points to the massive size of the Chinese market. And it's why Riccitiello pushed back on downplaying China's importance to Unity. The hope is that more game developers in China will start using Unity's software when creating and operating games.

For perspective, Unity generated 87% more revenue from the U.S market compared to China in 2022. But the Newzoo report shows the market size is the same right now from a revenue perspective, suggesting immediate upside in China if more video game developers turn to Unity's solutions. However, as previously stated, as long as geopolitical tensions are rising, there's uncertainty for companies like Unity looking to China for growth.

What it means for investors

Investors should care about what happens in China because of the pricey valuation of Unity stock. The company hopes to reach a $1 billion annual run-rate for adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) by the end of 2024. For comparison, its fully diluted market capitalization is about $15 billion. 

Trading at 15 times its 2024 run-rate for EBITDA is generous in my opinion. To be clear, I would say Unity's ambitious 2024 goals are already priced in today. Therefore, to have a chance at market-beating stock performance, it needs to grow substantially beyond its 2024 goals.

In order to grow substantially, Unity needs to take advantage of as many opportunities as it has. The video game market in China remains one of those opportunities for now. However, geopolitical tensions are still rising, meaning Unity's growth in China is hardly a sure-fire bet.

This is why Unity shareholders should be paying attention to what happens with China. There's nothing to panic about today and perhaps escalating tensions will soon stabilize. But Unity stock has valuation risk. Therefore, shareholders should remain aware of what's happening because it could affect future growth.