What it means
The sector covers a wide range of businesses. Software and cloud companies sell programs and subscriptions, hardware makers build devices and computers, semiconductor firms design and manufacture chips, and internet companies run platforms for search, shopping and social networking.
Large conglomerates in the sector may operate in several of these areas at once. Many technology businesses share some features.
They spend heavily on research and development, they can grow quickly because software can be copied at low cost, and they often have high gross margins (the share of revenue left after the direct cost of delivering the product). Stock market classification systems usually treat technology as one of the main sectors.
Some systems group certain internet and media companies elsewhere, so the exact list of companies in a technology fund or index can differ between providers. Checking the index rules before buying a fund avoids surprises about what it really holds.
Investors judge technology companies on different measures from those used for mature industries. Because many reinvest heavily, they may report low profits or losses, so analysts look at revenue growth, recurring revenue and measures such as the Rule of 40, a rule of thumb that adds growth and profit margin.
The Rule of 40 suggests that a company growing quickly can accept a lower margin, and vice versa. The sector is cyclical and competitive.
Customers cut technology budgets in downturns, products can be disrupted quickly by newer rivals, and valuations often swing sharply when interest rates or sentiment change. Competition for talent also pushes up costs, particularly for engineers.
For non-specialists, the key point is that technology also changes every other sector. Banks, retailers, factories and hospitals all depend on technology suppliers, so developments in the sector affect costs and competition across the economy.
Understanding how the sector earns its money helps managers negotiate better contracts with technology suppliers.
In practice
Real-world examples.
Example
An investor builds a portfolio and decides that 25% should be in the technology sector. She buys a fund holding software, chip and cloud companies to gain exposure. She reviews the holding every year and rebalances if technology grows beyond that share.
Example
A chip maker announces that demand for its products is slowing. Investors sell not only its shares but also those of other firms in the sector, because they fear a wider downturn. The episode shows how closely connected the businesses in the sector are.
Example
A manufacturing company moves its systems to the cloud and signs a five-year contract with a technology supplier. Its finance team must model subscription costs as a regular operating expense, not a one-off purchase. It also negotiates a cap on annual price increases to protect its budget.
Formula
Calculation
Rule of 40 score = Revenue growth rate + Profit margin
A software company grew revenue by 30% last year and has an EBITDA margin (earnings before interest, tax, depreciation and amortisation as a share of revenue) of 15%. Its Rule of 40 score is 30% + 15% = 45%, which is above the 40% benchmark. If its revenue was $200,000,000, the margin of 15% equals $30,000,000 of EBITDA.Case study
Seen in the real world.
Nimbus Analytics is an illustrative, fictional cloud software company with revenue of $80,000,000 growing at 35% a year. It reported a small loss because it reinvested most of its income in product development and sales.
The chief financial officer, Dev, told investors that the company's Rule of 40 score was 35% plus a loss margin of 5%, which equals 30%. He showed a plan to improve the margin by 10 percentage points over two years while keeping growth above 25%.
In this fictional story, investors accepted the plan because the target score of 35% was credible and moving in the right direction. The case shows how sector-specific measures shape the way technology companies explain their results. Dev now publishes the score each quarter with a short note explaining the movements, which has helped investors follow the progress without needing to read the full accounts.
Watch out
Common mistakes.
- Assuming every technology company is a fast-growing start-up, when many are mature and pay dividends. Several large technology firms pay regular dividends and buy back shares.
- Judging technology firms only on current profit, which ignores heavy reinvestment and recurring revenue. Metrics such as recurring revenue and customer retention give a fuller picture.
- Believing the sector is immune to downturns, when budgets and valuations can fall sharply.
Questions
People also ask.
What companies are in the technology sector?
Software, hardware, semiconductor, cloud, IT services and some internet companies, although classification differs between index providers.
Why are technology valuations often high?
Investors pay for expected growth and high margins, so prices depend heavily on future earnings and on interest rates. When interest rates rise, those future earnings are worth less today, which can push prices down.
Is the technology sector risky?
It can be volatile, because competition and change are rapid, so many investors balance it with other sectors.
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