Infosys Ltd held its annual analysts’ meet late last week. Investors should have been relieved to note that there were no incremental negatives in the company’s commentary.

The firm told analysts that there were no project cancellations or demands for price cuts after Standard and Poor’s downgraded the credit rating of the US economy. But there was no sign of relief on the Street—share prices of IT stocks continued to correct sharply last week.

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Valuations of Infosys and Tata Consultancy Services Ltd have corrected from 22 and 23 times predicted earnings, respectively, at the beginning of the current fiscal to 16 and 17 times, respectively, currently. Much of this fall has occurred this month, with markets the world over declining on fears of a global recession.

The moot question is if valuations are now attractive enough for long-term investors. Of course, valuations had fallen to much lower levels of 8-10 times forward earnings between end-2008 and early 2009. But then the demand situation isn’t expected to alter as dramatically as it had back then. As Infosys pointed out during the analysts’ meet, companies in developed countries have already factored in the uncertainty in the economy. As such, not many of them are expected to suddenly withdraw from projects in a large way. And, based on the experience in previous slowdowns, while growth may get affected in the short term, long-term prospects can be expected to remain healthy. Investors and analysts with this view would obviously find current valuations quite attractive.

But it’s important to note that in the current environment, news flow may continue to remain negative for some time. Besides, growth can be expected to be sluggish in the next few quarters because of the increased level of uncertainty in the economy. In such a backdrop, it’s quite possible that valuations may correct further.

Also note that even at current prices, the markets are pricing in fairly decent earnings growth rates for some time to come.

Using the reverse discounted cash flow method, Citigroup Inc. analysts point out that the markets are pricing in average annual earnings growth of 12.5% and 15%, respectively, for Infosys and TCS over the next 10 years. These stocks have corrected by 7% and 5%, respectively, after Citi’s report; which means that the implied earnings growth would be lower, but not by much.

Besides, as pointed out earlier, valuations are still some way off from their lows. In sum, while valuations seem compelling, there are enough reasons to be cautious as well.

Graphic by Sandeep Bhatnagar/Mint

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