Is it that software stocks are undervalued relative to the market? Will they outperform going forward? In our view, the risk-return matrix of investing in software stocks currently is equally poised.
On a relative basis, assuming a 15% CAGR growth in earnings of the BSE Sensex companies, the benchmark index is trading at a price to earnings multiple of around 14 times FY08 earnings. As compared to the same, the top five software majors, on an average, are trading at 19 times our estimated FY08 earnings. This is a 28% premium to the benchmark index. Considering the fact that earnings growth of the top three software companies i.e. Infosys, Wipro and TCS is likely to around 25% CAGR in the next three years (66% higher than Sensex earnings growth), we believe that the premium is justified
From: BSE IT: Has it tracked fundamentals
Question: Company A has a PE of 10, expected growth of 10 % for next 10 years and a ROE of 5 %. Company B has a PE of 15, expected growth of 8 % for the same period and an ROE of 20 %. Which company is cheap?
IT companies have a return on capital which is far in excess of 25%. However the key point in justifying the current valuations would be whether this level of growth and ROE hold? and that is where issues such as competivitive advantage of the indian IT service companies, their ability to contain costs, rupee ā dollar rates etc comes in. So basically the answer to the question posed in the above article is not as obvious as the writer is suggesting (at least to me)
I typically avoid reading broker reports and their recommendations. The analysis is typically very shallow, incomplete
and hardly covers any of the key aspects in valuing the company. And worse is the tendency to compare apples and oranges, which in this case is to compare BSE sensex (which includes banks, commodity companies etc ) with an IT services company.
Answer to my question: Company A is a value destroyer and would need capital to grow at 10 % for next 10 years. So I would not pay more than 4-5 PE for the company.
Comparing apples and oranges
C
how come ROE help in deciding answer to your question.
ROE is a very critical input in a DCF calculation. I will not able to give a detailed explaination in a comment.In short a company which earns more than its cost of capital creates value, whereas one which earns less destroys value.So if a company earns 5 % on capital, is destroying value. In theory the ‘owners’ of such a company could just sell the company and invest the money in goverment bonds and they would earn 7-8% on capital compared to 5%. In comparison a company giving 20% ROE and growing moderately is worth much more. As the ‘owner’ can compound his investment at 20% per annum.Another piece in the above query which i have not detailed, is the period of such excess returns. Here i have taken 10 years. For ex: a company which can have an ROE of 20% for 20 years is more valuable than the one which can do so for 10 years. This period i am referring to is basically the competitive advantage period. you can find link to this concept on the blog under the title competitive advantage
Hi Rohit, Dont you think ROE can be deceiving sometimes? Think of this case. I have a company which can increase sales by taking more loans and using it to promote sales. But it gets to a point wherein I am unable to grow sales unless I have cash to get the sales… and so I borrow more.. this is my classic company..NOw consider ROE..ROE = (Net profit / Sales) * (sales / Assets) * (assets / Equity) Simplify this to get ROE = NP/Equity.But since Equity = Assets – Debt, it doesnt tell me that I increased sales (and hence got more profits) by taking more debt.. In the equation, since sales and assets cancel out in numerator and denominator, and only the profit which is now on more sales (due to the huge debt serviced sales), is considered with equity, the company shows more ROE… But its destroying investors wealth, and contributing to debtors only.. the company needs to pile on debt just to maintain profits and hence ROE… So, dont you think ROIC is a better measure to talk about?
yes , i agree that ROIC is a better measure to look at. I typically use ROE or ROIC interchangeably because i tend to filter out companies with high levels of debtBut yes , the valuation exercise would be more sound ,with ROIC instead of ROE.
Hello,Ttainfomedia has a arbitrage opportunity,what will you do,buy for the buyback or ignore it.Regards,amit
Going back to the Dupont AnalysisROE = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity) I think the Prem might be a bit confused about this eqution. Although sales does get canceled out, it’s still an important element of ROE.Higher sales will increase asset turnover (sales/assets) which will raise Return on Assets which will raise ROE. If you collapse the Dupont Equation into two termsROE = (Net Income / Assets) * (Assets/ Equity)We see that ROE is a function of return on assets and the amount of assets that the equity controls.Equity consists of Paid in Capital + Retained earnings. If assets are greater then equity capital the company has financial leverage. The equity holders control and benefit from more income producing assets than they paid for.If you borrow money and use it to pay expenses then there is no increase of Assets(no increased leverage), but net income is decreased because from the interest expense. Each dollar of sales now generates less net income because of the extra interest expense. Therefore borrowing to cover *operating expenses* reduces ROE. If the borrowing used to pay for advertising increases asset turnover (Sales/Assets) more than it decreases profit margin (NI/Sales) then it will increase ROE