The first quarter results of companies have begun coming in. Typically, one notices that when the going is good and markets are booming, there is a race between companies to announce their quarterly results. This in itself should tell us about where corporate profits are headed.
However, it would be unfair to make a broad brush stroke and jump to conclusions. For instance, there is a general feeling that Infosys is all done for and TCS is the new star on the IT horizon. Let me point out that on some measure of profitability like operating margins, Infosys stands up better than TCS. The problem is that we are quick to jump to conclusions saying that Info-sys is now on the decline and TCS is on the ascent.
If one looks beyond the obvious, what stood out for me is that in this tough environment, Infosys added 51 clients out of which aro-und a dozen have a billing rate of $100 million per year. This is way ahead of TCS. The company has also diversified its customer base. Whilst the profit margins have declined, they are still above the improv-ed margins of TCS. Ultimately, the proof of the pudding lies in the nu-mbers that are delivered. I depend heavily on what a company earns on the shar-eholder money. In accoun-ting terminology it is refer-red to as Return on Equity.
Essentially, we take the profit-after-tax and divide it by the net worth of the company. After all, what better measure of efficiency could be there? Companies are in business to earn money. For instance, when I put money in an absolutely risk-free government of India paper, I am assured of around 8 per cent returns each year, with the principal fully gu-aranteed. In other words, if there is an earning potential of Rs 8, I am willing to pay Rs 100 for it. So, if there is something which earns 16 per cent regularly, I am willing to pay Rs 200.
And if a company can earn only four per cent on its shareholder money, I will not be willing to pay more than Rs 50 rupees for each share (assuming a face value of Rs 100). Now, if I look at Infosys and TCS, there is a huge difference on the earnings on shareholder money. TCS earns around 44 per cent on shareholder money and Infosys earns around 27 per cent only.
To me, TCS uses the mo-ney far more efficiently. Of course, one could argue that Infosys numbers are depressed due to the huge amount of cash sitting on its balance sheet (Infosys has around Rs 20,000 crore of cash or nearly Rs 70 per sha-re) on which it earns only some treasury returns. On a combined basis if Infosys earns 27 per cent, surely it earns far more on its business. So long as the management of Infosys continues to keep cash in the bank, the efficiency nu-mbers and the valuations will surely get affected.
For a book value of 126 and 518, TCS and Infosys had return on equity (RoE) of 44 and 27 respectively. Let me ignore the business and the growth for a moment and presume that the firms will be able to maintain this level of RoE. For this, let’s go back to the case of the risk free-ret-urn on a government paper being eight per cent.
When the RoE is eight per cent, I am willing to pay up to one-time book value. Thus, for TCS, with an RoE of 44 per cent, I am wi-lling to pay (44/8 X 126) around Rs 693 for each sha-re and for Infosys, with an ROE of 27 per cent, I am willing to pay (27/8 X 518) Rs 1,748 for each share. At the point of writing, the market price (in rupees per share) of Infosys was Rs 2,230 and that of TCS Rs 1,250. In other words, Info-sys commands a premium of around 28 per cent and TCS of around 80 per cent.
To me, this implies that the markets have high exp-ectations of growth in all parameters from TCS as opposed to Infosys. Thus, if I buy both shares today, I have a lower ‘margin of safety’ on shares of TCS as opposed to Infosys. In my framework, however, most shares in the markets will look overpriced. I assume no growth at all, thus putting me out of line with the world of analysts. Use my framework to figure out how much growth are you paying for.
The difference between my estimated fair value and the market price is the premium (or discount, as the case may be) you pay for your expectations of the future. Over time, big Indian firms will grow by not more than 12-15 per cent. This is in sync with a GDP growth of around seven to eight per cent each year.
(The writer is an independent analyst and can be contacted at balakrishnanr@gmail.com [1])
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[1] mailto:balakrishnanr@gmail.com