Information technology sector: how it makes money and what to watch

The information technology sector is made up of companies that build the software, chips, equipment and services that other businesses and consumers use to compute, store data and communicate. It is one of the 11 sectors in the GICS classification and is often seen as the growth engine of the stock market. Behind the single label sit several very different business models, so it pays to know which kind of technology company you are looking at.

What is inside the sector

Classification has shifted over time. Payment networks moved to financials in 2023, and companies such as Alphabet and Meta have been in communication services since 2018. StocksXray has a sector page for information technology, and examples such as Apple and Microsoft show how different two technology companies can be: one centered on devices, the other on software and cloud services.

How technology companies make money

Recurring software revenue. Many software firms sell subscriptions. Customers pay monthly or annually, so revenue is predictable and often accompanied by deferred revenue on the balance sheet when payment arrives before service is delivered. Gross margins are usually high because adding a customer costs little compared with building the product.

Cyclical hardware and chips. Semiconductor and hardware companies sell products whose demand swings with inventory cycles, capital spending and consumer upgrades. Their margins depend on utilization of expensive factories or on the product mix, and earnings can move sharply from year to year. These businesses need heavy capital spending and research.

Services. IT services firms bill for people's time and are tied to corporate budgets, so revenue is more closely linked to the economic cycle and margins are thinner.

Metrics worth watching

• Revenue growth and its source. Is growth coming from existing customers spending more, from new customers, or from acquisitions?
• Gross margin. High for software, lower for hardware. A falling gross margin can signal pricing pressure or a change in mix.
• R&D as a percentage of revenue. Innovation is the lifeblood of the sector, but spending needs to translate into growth eventually.
• Operating margin and free cash flow. Profit that turns into free cash flow is more convincing than accounting profit alone.
• Stock-based compensation. Many technology companies pay employees heavily in shares. This is a real cost that dilutes owners; see stock-based compensation and dilution.
• Software growth and margin balance. The Rule of 40 and SaaS metrics article covers a common shorthand: revenue growth plus profit margin should add up to a healthy figure.
• Customer concentration. A few large customers can account for a big share of revenue, especially for chip suppliers.

Example (illustrative numbers). Software company A grows revenue 30% with a 5% free cash flow margin. Software company B grows 10% with a 25% margin. By the Rule of 40, which adds growth and margin, A scores 35 and B scores 35. They look equal on the sum but are very different businesses, one reinvesting for growth and one harvesting cash. The shorthand is a prompt for comparison, not a verdict.

Valuation notes

Technology stocks often trade at higher multiples than the market because investors expect faster growth. That makes them sensitive to the discount rate: when interest rates rise, the present value of far-off earnings falls more, as explained in interest rates and the Fed. Price-to-sales is often used for unprofitable companies, but a sales multiple tells you nothing about whether profits will ever follow. Compare each company with relevant peers rather than with the whole sector, because software, chips and services deserve different ranges. See also growth versus value investing.

Risks and limits

• Rapid change. Products can be disrupted or become obsolete quickly, and a leader today is not guaranteed to lead later.
• Competition and pricing. Low marginal costs invite price competition.
• Cyclicality in hardware. Excess inventory can hit chip makers hard.
• Supply chain and geopolitics. Manufacturing is concentrated in a few places.
• Regulation. Antitrust, data privacy and export controls can change business conditions.
• Accounting choices. Capitalized software costs, acquired intangibles and adjusted profit measures that exclude stock compensation can flatter results.

Where to see it on StocksXray

Because every StocksXray metric is ranked as a percentile within the company's own sector, a software company is scored against other technology companies, not against banks or utilities. A stock page shows its fundamentals checklist, red flags such as dilution, and its peers, which helps you see where a company sits within the sector.

Key takeaways

• Information technology covers software, services, semiconductors and hardware, and their economics differ widely.
• Recurring revenue and high gross margins characterize software, while cycles and heavy investment characterize chips and hardware.
• Watch growth quality, gross margin, free cash flow, stock-based compensation and customer concentration.
• High valuations make the sector sensitive to interest rates and to disappointment.
• Compare each company with true peers rather than the whole sector.