However, over the last few months, as revenues and earnings have continued to grow at a triple digit rate, the stock has plummeted from $375 to $48. Market capitalization has fallen from about $25 billion to $3.2 billion in the last 18 months — a drop of over 87 percent! Might it be time to start buying Infosys? Can Infosys go any lower than it already has?
Before investors call their brokers to buy Infosys, they should ask themselves: What is Infosys really worth? What annualized rate of return can be expected if the stock were bought today? To answer these questions, one needs to understand how to calculate intrinsic value. The intrinsic value of any business is the sum of free cash flow it will generate from now to eternity, discounted to present value using a reasonable interest rate. (John Burr Williams, Ben Graham, Warren Buffett, et al.) For further insight into intrinsic value please see the article entitled “Intrinsic Value” in the July 2001 issue of siliconindia.
So, it’s fairly simple. If one can project the future cash flow that Infosys will generate, then its intrinsic value can be easily derived. Infosys had revenue and net income of $131 million and $39 million respectively for the quarter ended June 30th. While the company has grown at an annualized rate of more than 65 percent for the last seven years, it projects just 30 percent growth in the coming year.
High-growth companies appear to have growth engines that will continue to propel them unabated for decades to come. However history has taught us that even one-time market-dominating, rapidly-growing companies eventually mature to sedate or even negative growth levels. In the early 1970s, Xerox was a high-growth, high-P/E, high-flying stock that investors loved (one of the “nifty-fifty”). Investors were right in their assessment that photocopying was in its infancy and Xerox dominated copiers with strong patent protection and a big technological lead. Xerox’s stock price in the early 1970s was a historical high for the company. That price was never met or exceeded after 30 years of growth. A buyer of early 1970s Xerox shares would have found that, while document duplication has gone through an unprecedented growth curve in the last 30 years, Xerox has come to the brink of bankruptcy. For more recent examples, one can look at the growth rate projected for Oracle, Cisco and Dell five years ago and compare it to their projected growth rate for the next five years.
If Infosys grew 50 percent annually over the next 10 years, it would have a head count of 400,000 in 2011. That is a larger headcount than IBM, Cisco and Microsoft — combined. Clearly the 50 percent annualized is way off. I’d propose that it might be reasonable (even optimistic) to assume the company grows 30 percent next year (as management has guided) followed by 20-percent growth for the next three years, followed by 15 percent growth for the next three years followed by 10 percent growth in years eight through ten. Further, let’s assume that the company is sold in 2011 for its cash on hand plus 10 times its 2011 earnings.
I don’t think I’d be too far off in speculating that the average siliconindia reader is not interested in making investments in companies like Infosys to earn a five or ten percent annualized rate of return. Presumably, the reader is looking for 15-20 percent annually (or more). We now have all the data necessary to figure out if shares of Infosys ought to be bought at $48. Table 1 shows the present value of all the future cash flow Infosys will generate under the aforementioned assumptions.
Infosys has 66.1 million shares outstanding at present. The company has an excellent stock option program for its employees. Assuming a 3 percent annual dilution in shares outstanding leads to 88.8 million shares outstanding in 2011. This yields a price of $38 per share. In other words, if all of our assumptions came true, an investor buying Infosys today at $38 per share can expect a 20 percent annualized rate of return over the next 10 years.
Ben Graham suggested a substantial margin of safety when investing in any common stock. We don’t know what the future holds. To get downside protection, Infosys should be bought at a minimum 50 percent discount (margin of safety) to intrinsic value or $19 per share. If one desired a 15 percent annualized rate of return, then one could buy Infosys for up to $29 per share with a 50 percent margin of safety. Conversely, if one were (like me) looking for a 30 percent annualized rate of return with a 50 percent margin of safety, Infosys should be bought at no more than $10 per share — a fifth of its present price. Buying the stock at $48 with a 50 percent margin of safety would yield the investor an annualized return of just 3.9 percent.
Intrinsic value is a simple concept, but very difficult to precisely calculate for most companies. The best that one can do is to make conservative assumptions and then add a significant margin of safety. The message of this article is not to suggest the price at which Infosys should be bought or sold, but rather to give the reader a simple toolset to evaluate whether to invest in any given publicly-traded company. To start, investors must have a good idea of the rate of return they’d like from a given stock. They should know the company well enough to assess its future prospects. In growing companies, one needs to remember that no tree grows to the sky. Be conservative on future growth prospects. Finally, add a substantial margin of safety.
But, one might argue, what about the value of all the intangibles of great management, brand, client base, etc.? What about the value of the terrific talent Murthy and his team bring to the table? The answer is simple. All the intangibles are very relevant, but they are the reason the company will do so well in the future. I would not be optimistic that a second- or third-tier IT services firm in India will even be around 10 years from now. American Express, Boeing and IBM all have exceptional brands and intangibles. These intangibles are very relevant to shareholders and they do lead to sustainable competitive advantages that finally trickle down to cash flow that the company generates. All of Infosys’ intangibles are fully appreciated and have been implicitly factored into its future cash flow projections. If a competitive advantage does not eventually translate into cash flow then it is not a competitive advantage that’s relevant to investors.
It might be an interesting exercise for the reader to calculate the intrinsic value and future return expectations of all the stocks in their portfolios. The results will probably be surprising. Investors would be well served to look for great businesses within their circle of competence and then calculate intrinsic values for those businesses based on their annualized return expectations. The data would call to take a pass on most companies. Occasionally, however, Mr. Market will throw out a fat pitch. You know what to do then.
Mohnish Pabrai is the managing partner of Pabrai Investment Funds. He can be reached at mohnish@corp.siliconindia.com
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