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Software: What’s the ‘value’? - Views on News from Equitymaster
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Software: What’s the ‘value’?
Sep 20, 2005

India’s software industry has been the poster-boy of the country’s success in the services sector. The industry has grown at a strong pace over the past few years, despite the dot-com bust. In FY05, IT exports grew at 30.4% YoY and ITES-BPO exports grew at an even faster 44.4% YoY. With Indian companies like Infosys and TCS having virtually perfected the art of ‘global delivery’, the global IT industry has witnessed a paradigm shift in the way business is done. The dynamics of the industry have changed completely, driven by ‘disruptive innovation’, as Infosys likes to call it. Given that the industry has grown at such a fast clip and is likely to continue to do so in the foreseeable future, we give a perspective on valuations that are enjoyed by the top five software companies and make some sense of them.

Highly ‘valued’!

One must understand the basis on which markets value a particular sector. By and large, the growth prospects of the sector, the domestic economic scenario, global macro-economic variables, cyclicality of that particular industry, regulation (highly regulated industries generally get a discount), favourable policy environment, availability of manpower/resources and other such factors are the ones that markets consider while valuing a sector. The companies in the sector will accordingly get valuations based on their market positioning, the level of competition prevailing, the company’s breadth of offerings, strengths in niche areas, management quality and other sector-specific metrics, among other factors.

Based on the above metrics, software, being a high-growth industry, will get a premium as compared to other industries like automotive, oil and gas, banking, petrochemicals and steel. India’s attraction as an offshoring destination is its low cost and high quality skills. Offshoring is also becoming more mainstream, as witnessed by the recent ABN Amro deal. Further, top Indian software companies are well positioned in terms of management quality and scalability to take advantage of the high growth expected. Therefore, companies in the sector will get valuations more or less in line with their expected growth rates.

As can be seen from the table below, most of the software companies are valued at fairly high price to earnings (P/E) multiples. These range from the mid-20s to the mid-30s. In terms of enterprise value (EV) per employee as well, valuations are a multiple of the revenues per employee that these companies are able to generate.

Software stocks: Higher valuations for a reason!
(FY05) EV/Emp. (Rs m) Rev./Emp. (Rs m) P/E ratio (x)
TCS* 18.4 2.6 34.0
Infosys 21.1 2.3 35.7
Wipro** 15.0 1.7 32.8
Satyam 9.2 2.1 24.7
HCL Tech* 7.1 1.6 24.2
* As per US GAAP
** Only for IT services and BPO

Clearly, markets are willing to give higher valuations in terms of EV per employee than what these companies earn per employee. EV implies the sum of market capitalisation and debt, less the cash levels of the company. It is more or less a standard against which a potential acquirer would decide what price to pay if it was to acquire the firm. This measure can be compared with the revenues per employee generated by the firm. Thus, TCS, the largest company of them all, is valued at an EV per employee of Rs 18.4 m. It earns revenues per employee of Rs 2.6 m and thus, the EV/revenue (as a proxy to market cap to sales considering the low debt levels) is over 7 times.

However, Infosys gets the highest valuation among these companies. This is not at all surprising, as the company has been a model of consistency in performance. Not just that, the company’s management is truly visionary and its execution excellence in well known and acknowledged throughout the industry as well as by satisfied clients, a metric that is proved by the fact that over 95% of Infosys’ revenues come from repeat business. The market gives the company an EV of Rs 21.1 m per employee. The company earns revenues per employee of Rs 2.3 m, thus giving and EV/revenue of over 9 times, compared to 7 for TCS, its larger competitor.

It must be noted that TCS is much ‘younger’ than Infosys in terms of time listed on the markets. As TCS starts to improve the quality of its disclosures and becomes more ‘market-friendly’, this gap could reduce in future. It should be noted that TCS earns higher revenues per employee than Infosys and has operating margins that are not much lower. Therefore, there is a case for stating that this difference in valuations might be temporary.

As far as Wipro is concerned, its EV/employee is considerably lower than both Infosys and TCS. This could be partly due to the fact that Wipro has a lot of employees in BPO, where generally, productivity is lower, especially in the voice segment. In fact, in FY05, revenues per employee in BPO were just Rs 0.5 m, compared to Rs 2.4 m in IT services. Thus, to that extent, Wipro gets a discount. Overall revenues per employee are just Rs 1.7 m, considerably lower than both Infosys and TCS. This is obviously reduced by the lower productivity in the BPO business. We have not taken consolidated figures, just figures for IT services and BPO, to make the comparison more meaningful.

Going forward, Wipro is clearly facing challenges in the integration of its BPO and IT services businesses. Attrition of key personnel like Vivek Paul and Raman Roy has not helped either. We believe that the company needs to settle down and take further initiatives regarding getting more revenues from non-voice services in BPO, apart from regular movement up the software value chain. Once this happens, valuations could see an upside.

As regards Satyam and HCL Tech, clearly, these two companies command a significant discount to the top rung players. This is due partly to issues relating to management and inconsistent past track record. Satyam has faced problems with making investments in unrelated businesses in the past. The company has suffered badly on this count. However, recent initiatives taken by the management relating to pruning the subsidiaries under its fold and cutting investments in loss-making units appear to be yielding results and the consistency of the past two years needs to be maintained if the stock is to warrant higher valuations. EV/employee is Rs 9.2 m, while revenues per employee at Rs 2.1 m are not much lower than those of Infosys. Thus, there is scope for an upward movement of valuations, provided consistency is maintained.

HCL Tech, on the other hand, also gets a substantial discount to its peers. EV/employee of Rs 7.1 m is one-third that of Infosys. Revenues per employee are also considerably lower at Rs 1.6 m. Thus, the stock trades at a discount to the top four players. Consistency in its performance, particularly in IT services is what the company needs to show going forward, in order to command better valuations. The management has said that the past few years were the investment phase and from this year onwards, expects the company to grow between 30% and 40%.


As we have seen, the sector does trade at fairly rich valuations. Of course, one cannot read this in isolation and it should be connected with the kind of growth prospects that the industry has. As mentioned above, offshoring prospects are very bright and with India being among the best destinations to offshore, markets give the sector higher valuations. Company-specific valuations depend on their specific metrics. Going forward, as the industry matures, it is possible that P/E multiples may settle at lower levels as growth rates and operating margins also stabilise at lower levels. P/E multiples in the mid-20s to mid-30s could come down in the region of 20 or thereabouts. It should be noted that we are not making any predictions, just giving a perspective. Therefore, whichever sector an investor would like to buy stocks in, he or she should be sure to assess the valuations based on the parameters that we have given in this write-up.

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