Stock market is a strange place. One day you are put on a very high pedestal with investors making a beeline for your stock and the next, you can come crashing down to the ground. While not exactly meeting the same fate, IT (Information Technology) heavyweight Infosys, certainly seems to have fallen off its lofty perch.
To be honest though, the reasons behind the fall are not completely unfounded. Quarter after quarter, the company has failed to live up to its reputation of being the sector torch bearer and has ceded considerable ground to its more agile, nimbler counterparts. In fact, it is being discussed in rather hush-hush tones at the moment whether the company does deserve the high valuation multiples that the street has placed on the firm. In other words, has the time finally come for a fundamental de-rating of the stock?
We for one do not think so. You see, to an extent, the company seems to have become a victim of its own high reputation. It had made us so used to the pattern of under promising and over delivering on the financial performance front that we had almost started taking it for granted. And thus, when that pattern finally broke, it made investors quite nervous.
In the larger scheme of things though, it does remain amongst the best performing blue chips in India. After all, how many blue chips could boast of growing its topline and bottomline by 19% and 16% CAGR (compounded annual growth rate) respectively in the last five years and that too with virtually no debt? And with the IT outsourcing story far from over, there is no reason why a similar performance cannot be repeated over the long term period.
There's one more reason why a few quarters of underperformance should not lead to a fundamental de-rating of the stock. And this has to do with how the value of a stock accumulates over time. You see, unlike a bond that has a limited time period, stocks do not come with an expiry date and thus, their duration could be extremely long. Now, if we imagine that half the earnings of a firm are distributed as dividends and half reinvested in the business, we will have a stream of cash flows that will keep on growing at a constant rate in the future.
As shown in the chart above, nearly 25% of a firm's total value comes from cash flows in the first 10 years. And cash flows for the first 25 years account for only 50% of the firm's value. Now here comes the interesting point. You see, even if a firm's cash flows were to fall by 50% over the next five years, the total impact it will have on the firm's value is to the extent of just 5%. This is because 5 years worth of cash flows account for just around 10% of the firm's value. Besides, even if the problem lasts for 10 years, the value that will be eroded will be to the tune of just 11%-12%.
Of course, Infosys cannot keep on growing its cash flows for the next 100 years and hence, the erosion in its value is likely to be much more. But it should also be noted that it has not suffered fall in cash flows to the tune of 50% in the distant past. In fact, the main concern with the stock is that it will report lower growth in earnings and hardly any fall in the same for a sustained period of time.
Thus, to argue that the stock's P/E should be de-rated is a bit premature we believe. It still seems to have many good years ahead of it. And if the markets do make this mistake, loading up on the stock for the long term will be a high return and low risk proposition as per us.
Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.
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