analysing an IT services company stock

The IT service industry in india is currently getting high valuations and seems to have a very bright future . The typical PE are in a range of 40 + for the tier one companies.

The key point to understand is that the future of an good company can differ from the future of the stock. A company like infosys grew by 30-40 % from 2000 onwards. However the stock has gone from 10000 to 8000 (pre split ).

The future of IT companies definitely looks bright . The factors are fairly obvious and well know like trend towards offshoring , india’s IT manpower, cost differentials etc etc etc.

The problem is that all these factors are known by everyone and seems to be priced into the stocks. The tier IT companies sport PE’s of 40 +.

what does that translate in terms of market expectations . to put it briefly –

a) maintenance of the high Return on capital for the foreseeable future ( 5 years + )

b) Maintenance of the high margins / low capital requirements

c) moderate to high growth rates

d) Low probability of a shift in the basic business model / economics of the business

As long as the above expectations are met or exceeded , the stock should do ok or better. All of us can have differing opinions on each of the above factors . Whether right or wrong , only time will tell. But it pays to understand the underlying risks to each of the factors.

point a and point b are related. High returns over very long time is possible only if the companies have a very strong and sustainable competitive advantage. Do indian companies have that or are into labor arbitrage ? I would belive more of the latter (labor arbitrage ) than anything else. But to be fair they are trying hard to move away. If they do not succeed (having a sustainable competitve advantage is difficult in service business ) then the return / margins will go down.Also dollar – Re rate will have a negative impact on the two point if the dollar drops against the rupee ( a high possibility in the long run )

point c – Very likely high growth will continue for some time.

Point d – The current model itself is disruptive and may play out for some time . But in technology one can never be sure how things will be over 4-5 years. The concern is less if china or any other company becomes an alternative destination to india. Indian companies will expand to those location and use it to their advantage (already happening ). The bigger concern is what will be the business model 5 years hence. Will IT services still be required in the current form. Will technology replace a lot of work being done manually . This is hapenning already in voice activated system . So we can never be sure .And considering the amount of reasearch and innovation, it is quite likely to happen.

So it boils down to this : any one buying the stock is betting on the long profitability ( and not business alone ) of the IT services business in the current form ( high margins , high return on capital ). If one can be confident that it will continue for the next 10 years , then one will make money and deserves to for his / her foresight. Else you are following the herd and can lose money