Information technology (IT) stocks have outperformed the markets by a wide margin since the recent results season began. The National Stock Exchange’s CNX IT index has risen by 29% since Infosys Technologies Ltd kicked off the results season on 10 July. In comparison, the broad markets have risen by 9% in the same period.
The markets have been enthused about the fact that volumes and pricing haven’t declined sharply yet and that the financial services sector has stabilized. Recent results by Cognizant Technology Solutions Corp. suggested that clients are back to making decisions on discretionary spending, with growth in its application development work matching that of application maintenance.
There’s little doubt that things have improved in the past few months. And it’s not only Indian IT stocks that reflect this. Even the US’ Nasdaq Composite Index has outperformed the broad market this year.
But, at the same time, with Infosys’ one-year forward price-earnings multiple around the 20 mark, it’s time for a reality check on the valuations front. In this regard, Citigroup Investment Research has an interesting report which says that current valuations imply Infosys and Wipro Ltd need to grow their earnings before interest and tax by 10% and 12%, respectively, for the next 10 years.
Adding up: Wipro’s Bangalore campus. A Citi report says current valuations imply Infosys and Wipro need to grow their earnings before interest and tax by 10% and 12%, respectively, for the next 10 years. Hemant Mishra / Mint
This is based on a reverse discounted cash flow-based analysis, which uses a weighted average cost of capital of 11% and terminal growth rate of 4%. The Citi report adds that achieving this is unlikely to be easy. In the case of Tata Consultancy Services Ltd, the implied growth rate is slightly lower at 8%.
What’s more, current one-year forward valuations are back at the pre-slowdown levels in April and May 2008, the report says, based on Ibes (Institutional Brokers’ Estimate System) estimates at that point in time.
It’s important to note that while things have begun to stabilize, volumes are still not growing. Current prices are factoring in a recovery in volumes, but it may be a while before that happens.
A recent report by India Infoline Ltd’s institutional equities team says, “The project renewal cycle has almost resumed and most of the pricing negotiations are now done. However, decision cycles are still lengthy and we believe a stronger recovery in the second half of financial year 2009-10 is not on the cards. Also, clients prefer to wait for the budget release in 2010 before committing to higher discretionary projects.”
Investor sentiment is likely to be in favour of IT stocks in the near future as well, considering the sector is one of very few that will be unaffected by the poor monsoons in the country. But as far as fundamentals go, they don’t seem to support current prices.
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