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Software valuations: Low or high? - Views on News from Equitymaster
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  • Dec 13, 2002

    Software valuations: Low or high?

    Post the recent run up in technology stocks, Infosys is trading at a P/E multiple of 34x, while Wipro is trading at a P/E of 39x. Many investors are hesitant to buy these stocks at these levels due to the P/E multiple being over 30x. However, avoiding the stock based only on this reason may not be correct. There are many other things that need to be considered.

    Why such high P/E?
    Empirically, the P/E multiple reflects the earnings growth expectations for the next fiscal. Thus, if the markets are valuing a stock at 18x, they expect the earnings to grow by 18% the next fiscal. Thus, valuations for Infosys and Wipro point to expectations of strong growth in earnings, on the back of increased interest in offshore outsourcing. Unfortunately, only death and taxes are certain, outsourcing deals are not. If due to some unforeseen reason, the outsourcing order flow stops, then these stocks are likely to take a severe beating on the bourses. And valuations could revert back to 20-22x. Therefore, while investing at such high valuations, if the time frame for investing is short, the element of risk increases considerably. Consequently, it is advisable to invest with a long-term perspective (three to five years).

    Company CMP (Rs) EPS (FY03E) P/E (x) FY03E EPS growth
    Infosys 4,788 143.5 33.4 17.6%
    Wipro 1,620 41.5 39.1 3.6%
    HCL Tech* 190 16.6 11.4 10.0%
    Satyam* 283 14.1 20.1 17.5%
    Digital 622 32 19.5 12.9%
    Mphasis BFL* 692 41.3 16.8 63.8%

    * Consolidated numbers

    Company specific risks
    Also keep an eye out for company specific risks. Wipro P/E multiple is based on the company's low float. What if the management decides to offload a significant part of its holding in the markets? Even if the P/E declines to what Infosys trades at today (34x), investors will see the share price decline by 14%.

    Low P/Es?
    Traditionally in boom times, it has been seen that super growth stories mushroom overnight. These rosy projections make it seem that stocks are trading at relatively low valuations be it P/E or PEG ratios. But please do not get swayed by the noise around you. While many ideas are genuine, running a business is very, very difficult. First understand the company's business model, check out its historical financials and growth prospects, and finally establish management credibility. Only then can you gauge whether the valuations of a particular stock are justified or not.



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