Equity Valuation: IT SectorSubmitted By: - Submitted To:-Kushal Jain Dr. Brajesh Kumar20100019 Dr. Prageet AeronA (confidential) dissertation submitted in partial fulfillment of therequirement for the degree of Master in Business Administration at theJindal Global Business SchoolO.P. Jindal Global UniversityAugust, 2011
MEMORANDOMDATE: April 17, 2012TO: Dr. Brajesh Kumar and Dr. Prageet AeronFROM: Kushal JainSUBJECT: Dissertation Report on Equity Evaluation: IT SectorRespected Sirs,I have much pleasure in submitting the thesis on “Equity Valuation: IT Sector”The report has been made per the guide lines that were specified in the Dissertation Handbookthat was given to us at the beginning of it. This dissertation comprises about the evaluationmodel and valuation error. The dissertation discusses about the various methods of valuating afirm’s equity and to value the firms share for the coming future.This was nice experience in both studying the equity valuation and choosing the topic for thedissertationalso. The intricacies in getting the data for the concerned companies in the desiredfrom, which I came to know only after working on it.I thank you on my behalf for giving an opportunity to work on this topic. Yours faithfully, Kushal Jain
ACKNOWLEDGEMENTIam very thankful to Dr, Brajesh Kumar and Dr. Prageet Aeron for their continuous support incarrying out this dissertation.I express my sincere thanks to Prof. ManipadmamDatta, who laidthe basic step for choosing this topic for dissertation. I would also be thankful to other facultymembers who helped in getting the data for the analysis.We express our sincere gratitude to Mr. Ajay Tiwari for extending his helping hand in getting thedata from Prowess data base.I would also take this opportunity to thank my classmates (Nitish Mishra, Ankur Saraswat, andGautam Saini) in to be there by me at my difficult times in this dissertation.Finally I would like to thank my Parents for giving me the opportunity in studying in this collegeand for their continuous support which helped me in completing this dissertation.
1. IntroductionIn today’s era every company needs cash or cash equivalents to run its day to day activitiessmoothly. The major sources through which companies can borrow money are: Bank Loans Debenture PreferenceShare Equity ShareBank Loan is the amount which companies receive after fulfilling all the required informationwhich is mandate according to the rules of banks. Companies need to mortgage its assets asguarantee for the future repayment of its loan amt. on the loan bank charge interest whichcompany has to pay irrespective of the fact that company is in profit or loss. Debentures are theinstruments which are used to acknowledge the receipt of the debt form the debenture holders.Debenture Holdersare sought lenders for the company. They are usually medium or long-termdebts for the company. Debenture holders are also paid interest as per the contract betweendebenture holder and company. The interest has to be paid by the company whether company ishaving any profits or not. Preference share are kind of special equity. As they have both rightsof equity shares and debt instruments. Preference shareholders are been paid dividend at aspecified percentage of the share value. The dividend is been paid only when company haveprofits otherwise company have no obligation of paying dividends (depending upon the nature ofpreference share issued) to its preference shareholders. Equity Shares are the most riskyinstruments in comparison to all the instruments discussed above. Equity share holders are theowners of the company and they get only the residual dividends after all the interests are beenpaid. To save their stake in the company we need to do equity evaluation which will help inunderstanding the correct information about the value for their money. As equity is a veryimportant instrument for any company and the value of the stock itself justify it. Share value isdivided into two parts first the previous year’s profits and future expectation so share valuation isa very important aspect to judge companies working.
All assets have certain value. If a company wants to be successful in the market so they need tounderstand the importance of equity valuation for its main investor’s interest. Equity holders arebeen paid in the very last at the time of liquidation so it is very important to get equity valuationof a company. While calculating equity value determine the value of assets under uncertainconditions is difficult, since value of assets can be ambiguous. Therefore every public listedcompany must publish their financial statement on its website because it will help investors tounderstand the value of the firm by themselves. The biggest problem faced by the investors tounderstand which method to follow in calculating through which they would get the leastabsolute valuation error (AVE).IT sector is the most booming sector in the Indian market at this current era. It is the fastestgrowing industry in India and it has also provided huge employment to in Indian populationeither directly or indirectly. In the field of outsourcing Indian has become one of the mostrenowned name in the world because of IT industry. Contribution of Service sector in India’sGDP isaround: 53.7% in the year 2009 (Wikipedia). As the dependence of the Indian populationor investors are increasing in the IT sector in the same way the risk is also increasing. So tounderstand the industry and evaluate the risk factors through which we would be able to explainto the investors about the future prospects so that they can invest in this sector accordingly.Through this research we would be able to explain to the investor that where they should investand where they need to be bit cautious. In equity valuation we would be comparing differentmodels and would be analyzing which model provides the best result i.e. least absolute valuationerror. In this we will consider all the external facts as well what isthe impact of the accountingstandards, Political, social impact and others.2. Research Objectives To understand the different valuation models. To evaluate the equity of IT firms for the coming future using FCFF valuation model.3. Proposed Literature Review and Tentative Hypothesis
In the report of Penman and Sougiannis (1998) they studied the payoff between different discountmodels using ex post payoff method. They made a portfolio of the stocks of NYSE, AMEX andNASDAQ and then used dividend, Cash Flow and Residual Income models on it to fine the bestoutput model. The time period for which they examined was about 10 years and in the end they cameto a conclusion that Residual Income Model was the best among all in comparison to others.Francis, Olsson and Oswald (2000) also did a research on the same topic which Penman andSougiannis (1998) did. This time in place of individual data they used forecasted data which washighly unpredictable. Through their research they came to a conclusion that Residual Income modelis still better than the other models i.e. Cash Flow and Dividend Model.AswathDamodaran (2006) did a research using mainly three models in his paper and thosemodels are: Discounted Cash Flow Valuation Liquidation and Accounting Valuation Relative Valuation Contingent Claim ValuationAfter analyzing these they were able to find few trends from there research.Firstly there has beena shift in models of valuation i.e. from dividend discount model to valuing business whichrepresents models in which the price is been coded by the acquirer company. Secondly that allmodels are somewhat same but for that we need to take consistent assumptions which wouldhelp in getting précises results.As per the Modigliani and Miller (1961) who founded “Dividend Irrelevance Proposition” inwhich when the investment policy remains the same and company pays dividend but still thevalue of the firm remains the same as it was before. But in this case there are few assumptionswhich should be kept in mind while following this model and those are: The investors are rational, and have no effect form the earnings by capital gain or dividends.
The market in which investor are investing in a perfect market which means that no investor can impact the prices of the stock. There is no difference in the tax rates between income from dividend or income from capital gains. Perfect Insurance i.e. that there would be no difference between stock and bonds as being the source of finance.3.1 Valuation ModelsA valuation model consists of different valuation model which were to take every aspect ofvaluation under it. Through these approaches we would be able to find the best fit in relation tothe IT Sector.As per the report by Nathalie Söderlund (2006) there are six most important modelswhich need to be evaluated at the time of equity valuation process and all those models are: Assets Valuation Method (AVM) Present Value of Expected Dividends (PVED) Residual Income Valuation (RIV) Residual Income Valuation Terminal Value Constrained [RIV(TVC)] Abnormal Earnings Growth (AEG) Abnormal Earnings Growth Terminal Value Constrained [AEG(TVC)] Free Cash Flow to Firm (FCFF)Assets Valuation Method (AVM) is the way in which we consider that what will be the valueof assets if we liquidate it today. Through this we would get the current valuation of the investorsand if we will also be able to get the current market values of companies assets fromAswathDamodaran (2006).Present Value of Expected Dividends (PVED) method was recognizes by Williams [(1938,Cited in Nathalie Söderlund (2006)]. This model focuses upon the discounted value to the futuredividend and it is one of the simplest approaches to work upon.Residual Income Valuation (RIV)and Abnormal Earnings Growth (AEG)models are part ofconservative accounting procedure. Unconstrained and two types of constrained model
specifications are evaluated regarding their ability to withstand biases in book values andearnings due to accounting conservatism. As RIV and AEG both are part of “Clean SurplusRelation” which is an important aspect of conservative accounting process. (Skogsvik&Juettner-Nauroth, 2009)Residual Income Valuation (RIV) is mainly derived from the book value and it is part of thefirm’s total growth in progression. The total value under this method is been calculated by justadding the book value which there in owners book plus the residual amount which is been leftover this year (Skogsvik&Juettner-Nauroth, 2009).Abnormal Earnings Growth (AEG)model was introduced by Ohlson and Juettner – Nauroth(2005, in Nathalie Söderlund (2006)]. This model is mainly calculated by taking future profitsalso into consideration till perpetuity.Residual Income Valuation (RIV)and Abnormal Earnings Growth (AEG)parsimonious versionswhere the terminal value is set to zero at the horizon point of time. Through this we would be ableto followconservative approach to take the steady growth of the company all this could be takenunder Residual Income Valuation Terminal Value Constrained [RIV (TVC)]and AbnormalEarnings Growth Terminal Value Constrained [AEG (TVC)].In FCFFmodel the future cash flow is been considered for the valuation in place of the dividend inPEVD model. In this the value is taken into calculation is the amount which is been left over afterall the expenses and the money which is to be reinvested is kept aside.In order to understand the differences between all the models we have bifurcated it into differentconcepts. So these concepts are: Conservative approach is process when company takes all the losses at the time of expectation and profits at the time of occurrence. Dividend Basedapproach means take the future dividend discounting into consideration for its calculation. Cash Based means when dividend in not been discounted but the future cash vales is been taken into mind while valuation.
Terminal Value approach follows the final amount which is their in the hand of the investor at the time of liquidation of the business.Basis AVM PVED RIV RIV (TVC) AEG AEG (TVC) FCFFConservative Dividend based Cash based Terminal Value Table 13.2 Tentative HypothesisTo make our research successful we need to work on few hypotheses which would prove ourresearch that what all we assume are valid or invalid and would help us to give thee answer forour research. The hypotheses which we would be considering are:Hypothesis:FCFF provides no significant difference in absolute errors results compared.Penman and Sougiannis (1998) and Francis, Olsson andOswald´s (2000) results indicate the RIVmodel provides less valuation bias compared to both FCFF and PVED. This will be investigatedfurther in hypotheses 8-11, including both the constrained and unconstrained versions of RIV andAEG.4. Aim of the ResearchThrough this research we are trying to understand the important equity valuations models. Howand what are the impacts of these valuation models. We are here to understand a best investmentmodel which would comprise of a portfolio of securities which would generate profits in thecoming future. As a best model has not yet been found but we will try to reach as close aspossible to it through our research by doing robust calculation and using appropriate models..The main focus would be to value the equity of IT firms by using FCFF model through which wewould be able forecast the values in the coming future and which are very close to the market
value. Hence, the investment model will have the ability to withstand the factors causingvaluation error will be empirically evaluated. The primary idea behind this research is tounderstand the results provided by the FCFF investment models to the market prices and observehow large valuation errors occur.We also want to study the effect of the accounting standards in at the time of valuation as it is alsoone to the important aspect which should be taken into consideration while calculating and theimpact of it on any model. As there are there would be change in the Accounting Standards fromAccounting Standards to International Financial Reporting Standards (IFRS). So we what thisshould also be taken into consideration and our model must consider inherit risks form thevariation of these standards.The main idea for this research was to sundersatnddifferend valuation models and to predict thepices of the equity of the IT firms using FCFF model. We want to reduce the risk of uncertainty forthe investors at the time of selecting an IT stock in our portfolio.5. Investment Valuation ModelsIn a normal accounting process all the assets are been kept at book values and are beendepreciated at the prescribed rate by the Companies Act/ Income Tax Authorities of India. But inthe process of valuation models are considered as pro forma accounting methods with variousregulations for what to be valued in order to represent the value of equity. Different types ofvaluation models use different ways of calculating present values like discount valuation model,calculating future payoffs back to present value to deduce the equity price. 5.1. Basic Assumptions for valuation models are: (a) Dividends and new issues are to be settled at the end of coming time period and on the marked to market basis. (b) Future risk of investments are been considered in either discount rates or as the part of required rate of return over a certain equity/debt. (c) Valuation of the companies will be done taken time to be zero. 5.2. Discount Rate
Every investor has its own risk appetite therefore their return over the investments also varies with their risk profile. But for this paper we have taken a common required rate of return which is been calculated using CAPM (Capital Asset Pricing Model). This model is considered to be a good evaluator of the required rate of return for the investors. The Model is rP= Risk Premium βE = Beta of a particular stock rF= Risk Free rate of return 5.3. Free Cash Flow to Firm, FCFFUnder this valuation model we need to take the firms free cash into consideration. To get to thevalue of the firm we will discount it with the Weighted Average Cost of Capital (WACC) returnrate which will also be assumed as barrier rate over which a company had to pay to its investors.The things we need to take out from a company’s balance sheet to calculate FCFF areEBIT*(1-t)+ Depreciation-1Change in net working capital-Capital expenditures .=Free Cash Flows to Firm (FCFF)Formulation of FCFF: V0FCFF= ∑ E0(FCFFt)/Rwacct+ [E0(FCFFT+1)/(rET+1-g)]/RwaccTFormulation of WACC: rwacc = D/ (D+E)*rD*(1-T) + E/ (D+E)*rE6. Research MethodologyThis research would be mainly exploratory based and the data which will be used is somewhatsecondary because for this we need balance sheet of the companies and those balance sheetswould be available on the website of the company. This research would be primarily lab based aswe would be observing the share prices of the IT stocks as well while we would be doing all thecalculations which would be required to conduct our research appropriately. In this research we
would be analyzing different valuation models on previous 5 years (2005-2010) financial reportsof the companies mainly from IT sector. We have to understand method(FCFF) and our mainaim is to find out the model which is most accurate to understand the company’s market priceand from the average we get the smallest absolute variation error. We will analyze 3 companiesof IT sector form 2010 to 2017Expected (E). The underlining rational through which we canunderstand and forecast the future pricing. This would help investors to arbitrage the gap and getthe best of the investment plan.In this whole proposition we would have to take few assumptions which would help our model tobe work successfully and we understand that through those assumptions the accuracy of ourmodel would not be 100% but we need to take those assumptions which will not drasticallychange our research model.Through this we would be able to understand all the models and their impact on the IT Sectorand their future implications.7. Valuation MethodologyAll the derived prices are compared with the market price of that company. The market price isalso the adjusted closing price of that company.For the FCFF model we have taken Change In working Capital from Cash Flows Statement(CFS) generated by the company. For capital expenditure we have taken it from the Cash Bookvalue of the stock is been expressed by dividing the total equity value in the balance sheet by theno. of shares mentioned in the balance sheet and is used as an estimator for Bvt.Dividend is the amount which is been paid by the company to its investors. The dividend should bepaid to the same no. of investors which are mention in the balance sheet. Dividends per share areused as an estimator of Divt.The earnings per share are the amount of company´s profit in per share terms. Hence, the totalprofit divided by current outstanding shares of common stock. Earnings per share are used asan estimator for Xt.
The price per share represents the market price of the value of owner´s equity per common share.Price per share is used as an estimator for Pt, calculated by taking the average share price of theyear.Flows for Investing Activates in the cash flows statement generated by the companies itself. Thetax is been taken as the tax paid which is written in the CFS. Depreciation was been separatelygiven either in the Income and Expenditure Statement or in the Expenditure Schedules of theCompanies.We have calculated discount rate, beta of the equity and growth rate by our own set ofcalculations. AS all the mentioned information is not directly present in the balance sheets of thecompanies tax rate is been taken as 30% as it is the corporate tax rate in the country 7.1. Tax Rate (t)For all the calculations tax rate is been taken as 30% which is equivalent to the corporate tax rateapplied by Income Tax Authorities of India. We would require tax rate for calculating discountrate, WACC, FCFF. 7.2. Discount rateThis section explains how the cost of equity and cost of debt´s inputs were calculated.7.2.1 Risk Free Rate (rE)Risk free return securities are the minimum risk return securities. It is used to calculate both thecost of equity as well as cost of debt. It is been used in the formulas in calculating the beforementioned. It is the rate at which RBI Bank tends to take money from the market. The currentrate sa on 30-3-2012 prevailing at 8.5%p.a7.2.2 Cost of Equity (rE)It is the cost which is somewhere equivalent to the expectations of the investors from the stocksof the company. It also includes beta into its calculation which tells an investor the systematic
risk which investor is taking by buying a stock of a particular company. Beta value tell us the responsiveness of the stock in comparison to market movement. 7.2.3 Cost of debt (rP) It is the rate at which company is able to get its loan from the market. It is used to calculate Kd in WACC. Cost of debt includes the cost of defaulting in addition to risk free return. 7.3. Growth rate (g) It is very important to understand the growth rate of the IT sector. We have taken it to be above the average of the growth rate from the years 2005 – 2010 to 35%p.a. As in this period the IT companies have seen the best as well as the worst periods in the recent times so we assume that this will be a good proxy for future projection for the coming 5 years, after that the IT sector will also saturate and will grow at a rate of 25%p.a. till infinity. 7.4. Valuation Assumptions The companies will grow approx. 35%p.a by revenue till 2016 After 2016 companies will grow at 25%p.a till perpetuity Expenditure rate will be same as it is of the average of (2005 to 2010) revenue CAPEX and Change in Working Capital is based on PAT (After Extraordinary Items) Deprecation is based on the increase and decrease in the CAPEX in the last year Betas of the firms are on the bases of the prevailing betas values in the financial years 2005 and 2006 for the calculation for the 2011E till perpetuity Debt to Equity ratios are based on the current years  ratios Market return is been taken2011E 2012E 2013E 2014E 2015E 2016E 2017E Till Perpetuity43.5 42.5 41.5 41 41 41 36 36
Risk Free rate is been considered as2011E 2012E 2013E 2014E 2015E 2016E 2017E Till Perpetuity 8.5 7.5 6.5 6 6 6 6 6 We have not taken year 2009 into calculations as that year’s data is very wearied and is nowhere useable for the calculations purpose. 8. About Companies 8.1 Infosys An Infosys technology LTD. was started by seven entrepreneurs Nagavara Ramarao, Narayana Murthy, Nandan Nilekani, Kris Gopalakrishnan, S. D. Shibulal, K Dinesh and with N. S. Raghavan. It is one of the oldest IT solutions Company in India which was established in the year 1981. It was officially begin with US $250. During the first two years of its existence it didn’t have a computer but still they are able to take the company to such a high level which we all couldn’t think off. Infosys is a global company and it has 64 offices and 68 developed centers in India, China, Australia, The Czech Republic, Poland, U.K, Canada and Japan with a global workforce 145,088 till 31st December 2010. Infosys was the first company to use Global Delivery Model (GDM) which is now been seen as most beneficial for the company in getting the offshore contracts for the company. GDM follows the principle of taking work to the best available talent which is economically sensible for the company’s growth. 8.2 Tata Consultancy Services Tata Group is a very well-known name in the Indian context. Tata Group is the one of the oldest companies in the Indian market. It was started in the year 1868 by its founder Jamshedji Tata. Tata Group is a much diversified group as it has companies in steel, energy, retail, communication, information technology (IT), and many more. Tata Consultancy Services (TCS) is subsidiary of Tata Group in the field of information technology industry. TCS is raked at 20th spot in the list of Fortune India 500 magazine. It is the largest technology provider company in India.it was started in way back in 1969 and since then it has around 142
offices in 47 countries. It generates around 30% of the Indian IT exports revenue from itsservices.8.3 Wipro Ltd.Wipro was started in the year 1945 by Mohamed HashamPremji. In the beginning WiproLimited was known as Western India Products Limited. Initially it was been setup as a vegetableand oil manufacture company. As in the year 1966 the visionary AzimPremji became thechairman of the company started doing changes and changed its business to IT outsourcing. Intoday’s time Wipro is around 120,000 employees working for it. It is 9th most valuable brand asper the survey done by Brand Finance and The Economics Times in the year 2010.9. ResearchAs in the above section we have undertaken different valuation models for our understanding butnow we are trying to predict the future equity valuation of the companies which comes under theIT sector. For this we have taken the previous data of the companies from their respectivewebsites and balance sheet. We have extrapolated it till the year 2017E. For this we have takenthe growth rate above the average of the growth rate form the year 2005 till 2010 to be 35%p.a.As this was the period which has seen the worst and the best times in their business cycletherefor it will be a good proxy for us to take in the coming future. Till 2016E we have taken theaverage rate and after that we have considered 25%p.a to be the growth rate as we expect themarket to saturate a bit and few more to add in which will slow down the growing pace of theundertaken companies. We have taken the expenditure to be the average of the % of revenue forthe future as well. By taking this we are able to come to a situation wherein we have the profitsof the companies till the year 2017E (Table 1 – Table 3). By using the WACC of the respectivecompanies we will discount it year wise to get a value for the firm.
ReferencesAswathDamodaran (2006) - http://people.stern.nyu.edu/adamodar/pdfiles/papers/valuesurvey.pdf(Skogsvik&Juettner-Nauroth, 2009) - http://swoba.hhs.se/hastba/papers/hastba2009_011.pdfNathalie Söderlund - (PDF: Equity Valuation - An examination of which investment valuation method appears to attain the closest value to themarket price of a stock)Penman and Sougiannis (1998) - http://www.allbusiness.com/accounting/methods-tandards/806056-1.htmlGDP facts - http://business.mapsofindia.com/india-gdp/sectorwise/Fisk free rate –http://indiastat.com/