Software Bear Market: 2 AI Stocks With 42% and 47% Upside to Buy Now, According to Wall Street

The S&P North American Technology Software Index, which tracks 110 software stocks, has fallen 26% from the all-time high it hit in September. The puts the index in bear market territory, and artificial intelligence is the root cause.

Specifically, investors are worried AI code generation tools will reduce demand for existing software products, but Nvidia CEO Jensen Huang is very skeptical. "There's a whole bunch of software companies whose stock prices are under pressure because somehow AI is going to replace them," he said at a recent event. "It is the most illogical thing in the world."

Indeed, Wall Street thinks Microsoft (NASDAQ: MSFT) and Datadog (NASDAQ: DDOG) are deeply undervalued at current prices.

• Among 60 analysts, Microsoft has a median target price of $600 per share. That implies 47% upside from its current share price of $409.
• Among 48 analysts, Datadog has a median target price of $180 per share. That implies 42% upside from its current share price of $126.

Here's what investors should know these AI stocks.

Image source: Getty Images.

Microsoft: 47% upside implied by the median target price

Microsoft enjoys a strong position in enterprise software, particularly in office productivity, enterprise resource planning, business intelligence, and low-code development tools. The company has supercharged its software products with generative AI copilots, which improve productivity by automating work. Paid Microsoft 365 Copilot seats rose 160% in the December quarter, according to CEO Satya Nadella.

Meanwhile, Microsoft Azure is gaining market share in cloud computing. The company accounted for 21% of cloud infrastructure and platform services spending in the December quarter, up from 20% in the September quarter. Market share gains were driven by increased compute capacity and demand for Foundry AI services, which let developers build custom AI agents and applications.

Azure is the only major public cloud that provides access to OpenAI frontier models via application programming interface, which means Microsoft is often the middleman when companies build custom applications with those models. Beyond that, Azure has a distinct competitive advantage in its support for hybrid clouds, according to Morningstar analyst Dan Romanoff.

Microsoft shares currently trade at 26 times adjusted earnings, an attractive valuation for a company whose adjusted earnings increased 24% in the most recent quarter. With the stock down 25% from its high, the current price is a good entry point for patient investors.

Datadog: 42% upside implied by the median target price

Datadog develops observability and security software. Its platform includes two dozen products that help businesses monitor and protect critical IT infrastructure and applications. One particularly interesting feature is Watchdog, an AI engine that automates anomaly detection, incident alerts, and root cause analysis to help teams resolve incidents more quickly.

Artificial intelligence should be a tailwind for Datadog. Forrester Research recently ranked the company as a leader in AI for IT operations, a discipline that aims to improve IT efficiency with machine learning. Additionally, Gartner has recognized its leadership in digital experience monitoring and observability platforms, listing AI insights and support for large language model monitoring as key strengths.

Morgan Stanley analyst Keith Weiss says Datadog's ability to consolidate a broad range of performance monitoring tools on a single platform, something that has become a top priority for many IT departments, has made the company "the top share gainer in its core observability market for several years." He expects that trend to continue as cloud adoption and AI create incremental demand for performance monitoring tools.

Datadog reported solid fourth-quarter financial results. Revenue increased 29% to $953 million and remaining performance obligation increased 52% to $3.4 billion, which hints at strong future revenue growth. Meanwhile, non-GAAP net income increase 20% to $0.59 per diluted share, growing slower than revenue because of heavy R&D spending.

Datadog shares currently trade at 60 times adjusted earnings, an expensive valuation for a company whose adjusted earnings increased 20% in the most recent quarter. But earnings are likely to accelerate in the future as the proliferation AI workloads drives demand for observability software. I think patient investors should consider buying a small position today.

Trevor Jennewine has positions in Nvidia. The Motley Fool has positions in and recommends Datadog, Microsoft, and Nvidia. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy.