A humble attempt at building a purely numbers driven and objective framework for evaluating IT services companies. The presentation tries to explain the same by using Mindtree as an example.

1. Mindtree DCF Valuation
Krishna Mahale
7/7/2016

2. Usage Guide & Disclaimer
• This presentation contains animations and
hence, it is best consumed in full-screen mode
• Note that this material is not a
recommendation for investing or divesting
securities and shouldn’t be interpreted as
such, nor should the same be considered
while making any investments or
divestments in any security

3. Mindtree – DCF Valuation
• Where to get the data?:
– http://www.mindtree.com/about-us/investors
• Mindtree reports consolidated financial results at
quarterly frequencies
• The key sections are organized as:
– Press releases
– Fact sheet reports
– Financial results
– Investor presentations
– Earnings conference call transcript (deferred update, till
such time the recordings are available on numbers
mentioned in the Event Calendar)

4. Mindtree – DCF Valuation

5. Mindtree – DCF Valuation
• Other IT companies maintain such disclosures in similar fashion as mandated by SEBI:
– TCS: http://www.tcs.com/investors/Pages/default.aspx
– Infosys: https://www.infosys.com/investors/
– Wipro: http://www.wipro.com/investors/
– HCL Tech: http://www.hcltech.com/investors/results-reports
– Mphasis: http://www.mphasis.com/financial-results.html
– Hexaware: http://hexaware.com/investors/
– KPIT Tech: http://www.kpit.com/company/investors/home
– Zensar Tech: http://www.zensar.com/investors
– NIIT Technologies: http://www.niit-tech.com/investors
– Cyient: http://www.cyient.com/investors
– Persistent Systems: http://investors.persistent.com
– 3i infotech: http://3i-infotech.com/3i-infotech/investors-2/
– E-clerx: http://www.eclerx.com/Pages/Corp_Investors.aspx
– Hinduja Global Solutions: https://www.teamhgs.com/contact-us/investor-relations
– Firstsource Solutions: http://www.firstsource.com/us/investors-overview
• Google: <company name> <investor relations>
• You may also get in touch with the investor relations personnel of respective companies to receive
periodic alerts for staying on top of potential developments in your investee company

6. Mindtree – DCF Valuation
• Basic steps in data cleansing:
– Always use LTM estimates. E.g.:
• If Mindtree recently declared results for quarter ending June 2016, aggregate all
numbers for last four quarters including the quarter ending June 2016
– Always project in 12 month time windows
• So the immediate projection in the above instance should correspond to year ending
June 2017
– This is done in-order to avoid the problem of seasonality
• However, there are some professions that thrive on preparing quarterly forecasts. Note:
its your money not theirs 
– Always prepare pro-forma estimates
• Mindtree acquired three companies during the course of FY2016. However, the full-
impact of the combined entity will not be seen in FY2016, since, there would be certain
non-zero periods in FY2016 where the acquired company results will not be consolidated
• Accordingly, FY2016 pro-forma estimated should make adjustments for such periods
• This also applies to operational data, but in most situations, there will not be enough
information for making adjustments to operational disclosures
• For companies that own real estate, a notional rent expense should be deducted at
market value
• Provisions for bad debt should be reversed while arriving at pro-forma estimates
– Never assume potential acquisitions while building projections or arriving at a
valuation estimate

7. Mindtree – DCF Valuation
• First we split revenues by the underlying economic driver
– Non-linear revenues: Mostly includes IPs, scales independently of costs
– Linear revenues: Services driven, costs tightly coupled with revenues
• Secondly, Mindtree is a export oriented company. Hence, to the extent possible
the financial entries should be segregated by underlying currency.

8. Mindtree – DCF Valuation
• Basis for 1 year forward revenue projections:
– IT companies, have very high annuity component in revenues. E.g:
Mindtree reported revenue contribution from repeat customers in the
96-99% range at annual lags
– So, 1yr forward revenues would have a stable relationship with current
1 yr forward order book
• Mostly, this datapoint is not available. In this particular case, we used a
surrogate measure that we could locate in the earnings transcript “Like I
explained in the early part of this call, our annual growth rates have been
ahead of 15% over the last three years and we believe we will look at some
similar sort of growth trajectory in FY’17 as well” – Rostow Rawanan (CEO)
– However, the same cannot be used for projecting beyond the 1 year
time window
– Note that guidance, such as the one provided above are generally
expressed in constant currency terms, especially when no other
accompanying assumptions are provided

9. Mindtree – DCF Valuation
• How to project farther into the future?
– Its generally difficult for mid-tier IT Services companies to
make a blockbuster entry into new clients
– Transformational outsourcing assignments are highly
structured and generally advised by established consulting
firms
– The vendor assessment frameworks are extremely mature,
where the vendor is objectively scored around various
factors, mid-tier companies are generally pitted against
large global companies with supremely mature capabilities
– Hence, it is reasonable to assume that mid-tier IT Services
companies can only hope to grow through client-mining

10. Mindtree – DCF Valuation
• Client mining model:
– Segregate clients by revenue tranche
– Assume probabilities of client jumping to a higher tranche
– Assume linear expansion for clients not making the jump
– Test assumed growth against above assumptions as shown below
5%
10%

11. Mindtree – DCF Valuation
• As next step we’d link costs to projected revenues. Key cost components are:
– Labor costs (66% of revenue)
– Travel & conveyance (5%)
– Rent (2%)
– Electricity (1%)
– Hiring costs (1%)
– Depreciation (3%)
– Income taxes (22-23% of PBT)
• Following is a skeletal diagram showing interlinks between these cost items
Headcount
Labor costs
Travel
RentElectricity
Depreciation
Hiring

12. Mindtree – DCF Valuation
• Labor cost model

13. Mindtree – DCF Valuation
• Employee costs are sticky and cannot be controlled at levels. We model the same
as follows:
– Calculate change in required headcount
– Add expected attrition numbers to arrive at gross headcount addition
– Subtract trainees coming out of training program for gross new lateral hires
• The same translates to costs as follows:
– Employee cost(t+1) = employee cost(t) – cost of attrited employees (t+1) + cost of new lateral
hires (t+1) + trainee cost (t+1)
• More assumptions:
– Attrited employees leave at average employee wage rates for the company with certain
adjustments
• What can be controlled?
– Trainee costs
– Costs of new later hires
• Further the above approach also allows for:
– Computation of average employee seniority
– Calculation of severance costs
– Provision for notice periods
– …through referencing of employee movements & underlying costs

14. Mindtree – DCF Valuation
• Following are certain high level assumptions:
– We have loaded travel costs into employee CTC as travel budgets are tightly controlled in-line with
employee CTC

15. Mindtree – DCF Valuation
• Other key assumptions
Parameter Unit Value
Computers ( 3 years) $/FTE 1,500
Furniture, other –onsite (5) 4,000
Furniture, other –onsite (5) Rs/FTE 200,000
Onsite real estate Sqft/FTE 25
Offshore real estate Sqft/FTE 141.5
Onsite real estate rate $/sqft pa 20
Offshore real estate rate Rs/sqft pa 422.1
Variable overheads % revenue 7%

16. Mindtree – DCF Valuation
• Final set of key assumptions
– The currency assumptions are in-line with results of IMF authored paper on exchange rate
expectation formation (https://www.imf.org/external/pubs/ft/wp/2011/wp11116.pdf)
– Currency inflation and region growth forecasts are obtained from IMF World Economic Outlook
– Folks can also refer to Consensus Economics' (http://www.consensuseconomics.com) long term
consensus estimates of expected exchange rate movements (this is a paid subscription)
– Tax rates have been progressively increased in-line with the long term marginal tax rates in India

17. Mindtree – DCF Valuation
• This is how our final output looks like:

18. Mindtree – DCF Valuation
• Now we have free cash flows, so the next step is
to compute WACC
• Since, Mindtree’s debt is negligible in comparison
to its fair equity value, WACC = cost of equity
• Cost of equity can be computed using CAP-M
– CAP-M is in-fact derived through minimizing portfolio
variance
– The final formula is
• E(rp) is the expected cost of equity
• rf is risk free return
• E(rm ) is the expected return of universal portfolio

19. Mindtree – DCF Valuation
• To estimate cost of equity we need to estimate the parameters in CAP-M
– Universal portfolio can be proxied with an index portfolio like Nifty50
– Risk free rate can be obtained as the yield on zero coupon 10 year GOI bonds minus the credit
default spreads for GOI
– GOI default spreads can be approximated using India sovereign rating issued by established
rating agencies
– So, β (0.2838) is in-fact the slope of Mindtree’s returns vs. Nifty50 returns as shown below
y = 0.2838x + 0.7236
R² = 0.003
-300.0
-200.0
-100.0
0.0
100.0
200.0
300.0
-20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0
Mindtreereturns
Nifty returns
Mindtree vs. Nifty returns
Parameter Unit Value
Beta 0.2838
Risk free rate pa 6.5%
Expected difference in Nifty and
risk-free returns
pa 9.11%
Expected cost of equity pa 9.1%
Should we use this value of cost of equity?

20. Mindtree – DCF Valuation
• As an alternative, instead of using WACC, we can also compute the returns implied
by Mindtree’s CMP (i.e. the IRR)
– The IRR is the rate of return at which the present value of future cash flows equals Market EV
• How to arrive at Market EV:
– Market EV = Market cap + Dividends paid out after most recent results + debt – cash
– Market cap = Current market price X outstanding shares
– Debt and cash positions can be determined from recent balance sheets
– Note that debt and cash means all external liabilities & assets of non-operational nature including
MTM value of outstanding hedges
• A quick test is to find out if the items are dependent or independent of the size of business
• However, its best to expense out some liabilities that are unfunded
At discounting rate of 8% pa the present value of future cash flows
is Rs109,302 mn, so we can conclude that the IRR is approx. 8% pa
How do we interpret 8% pa IRR?

21. Mindtree - DCF Valuation
• In summary we followed the following process to estimate
Mindtree’s equity value
– Understood revenue split and assessed potential future growth rates
for Mindtree
– The revenues were linked to Mindtree’s costs using Mindtree’s
revenue model which is mostly headcount linked
– Next we made some assumptions regarding some key macroeconomic
variables
– Finally, we computed Mindtree’s WACC which was found to be
inadequate for further analysis given the scrip’s relative illiquidity
– As an alternative, we tried to figure out expected returns if we were to
invest in Mindtree’s equity at CMP
– As an alternative, we can also refer to Mindtree’s valuation w.r.t. a
comparable peerset to arrive at potential inferences regarding
Mindtree’s equity value

22. Thank You