Jim Cramer: The market has turned against software stocks and this metric explains their downfall

Investors continue to run away from enterprise software stocks, and it’s too soon to call the bottom in the group, CNBC’s Jim Cramer said Thursday.

The reason? Cramer said as long as the market is concerned about artificial intelligence disrupting their once-loved business models, it’s impossible to determine what investors are comfortable paying for these companies’ future earnings.

Cramer is referencing a stock’s price-to-earnings multiple, which he described as the “secret sauce” to understanding how a stock trades. It measures how much an investor is willing to pay for each dollar of future profits.

“Can the market be wrong? Of course, it’s wrong all the time,” Cramer said on “Mad Money” after a brutal session for software stocks. However, he continued, “Can you get in front of the freight train that is the shrinking price-to-earnings multiple? Maybe not now, not yet.”

“Soon, when we see how low the multiple can go — and it will bottom — these may be worth buying because we’re dealing with great companies. Right now, that doesn’t seem to matter, but I bet it won’t stay like that forever.”

When a company is growing fast and investors are confident in the trajectory of those profits, they’re generally willing to pay a higher P/E multiple. When investors have less confidence in future growth, the P/E will get compressed. That’s exactly what is happening across software right now.

Cramer said the posterchild for this dynamic is ServiceNow, which fell 9.9% Thursday despite announcing a better-than-expected earnings report and huge buyback Wednesday evening. ServiceNow shares have tumbled roughly 49% over the past year, while the iShares Expanded Tech-Software Sector ETF is down about 11% in the same stretch. By contrast, the S&P 500 has gained about 15% in that timeframe.

“The earnings are fine. The problem is … what people will pay for those earnings,” Cramer said.

ServiceNow’s price-to-earnings multiple is shrinking dramatically, falling from the upper 60s in January 2025 into the 40s in April and continuing lower from there. After Thursday’s meltdown, ServiceNow trades at just under 28 times forward earnings.

“The [multiple] can be brutal. It’s like a vote, a referendum, and somehow [ServiceNow CEO Bill McDermott has been voted off the island,” Cramer said of the ServiceNow CEO. “The stock market has said, ‘Ain’t got nothin for you, Bill.'”

Cramer stressed that his own evaluation of ServiceNow’s future isn’t as harsh as the market’s, noting that McDermott was on “Mad Money” the prior evening telling a compelling story about the company’s ability to thrive in an AI-driven world.

“So, the question isn’t whether ServiceNow will keep delivering earnings. I think it will. But it doesn’t matter,” Cramer said.

“I accept the market’s judgment at least for now, because I can’t fight it,” he added. “It’s too powerful.”