How to Select a Right IT Stock | IT Sector Fundamental Analysis4 min read
In this article, we will understand the revenue source of the Information Technology (IT) Companies, what are the parameters to analyze this sector, and how can an investor analyze this sector. So, let’s get started!
Revenue Source of IT Companies:
- IT Companies generally generate revenue from Consulting, Business Process Management, Application Development & Maintenance, IT Infra Services, Engineering & Industrial Services, etc.
- The major expenditure of IT Companies are on human resource as the manpower required in this industry should be highly skilled and professional.
- The profitability of the sector largely depends on the efficiency of the management of human resources.
Important Characteristics of IT Companies:
1) Asset Light Business- There are no major assets for the IT Sector, there is no huge land, or factories, involved in the operations of the IT Industry.
2) Employees are the Backbone- The IT Sector needs highly efficient, skilled, and professional employees for smooth and better functioning.
3) Organized Sector With Leaders- In IT Sector, the top-4 companies largely own the dominant position.
4) Healthy Balance Sheet and High Cash Generation- Due to the asset-light business model, IT Companies enjoy a healthy balance sheet and high free cash flow.
5) Dependency on the US and Europe- The majority of the project for Indian IT Companies comes from geographical regions like the USA and Europe.
6) Currency Risk and Client Concentration Risk- Due to fluctuation in the India-Foreign Currency, there are effects on the revenue of the company. While all the IT Companies have high revenue dependency on few clients which gives client concentration risk to these IT Companies.
Important Parameters for IT Sector:
1) Revenue Per Employee:
- It refers to revenue generated per employee of the company.
- For Ex.: If a single employee of Infosys generates revenue worth Rs. 38.3 Lakhs during an accounting year. While a single employee of HCL Tech generates revenue worth Rs. 42.2 Lakhs during the same period.
- Since Employees are the main workforce of IT Companies, it becomes important to analyze the efficiency of an employee.
2) Attrition Rate:
- Attrition Rate is a measure that reports the rate of loss of an employee during the trailing twelve months (TTM).
- This rate should be lower for the company as a higher attrition rate indicates that employees are leaving frequently which can cause a problem.
- For Ex.: For Infosys, the attrition rate is 28.4% on a TTM basis, while TCS reports the lowest attrition rate of around 19.7% during the same period.
3) Total Contract Value (TCV):
- It refers to the total business which can be generated with a particular project/contract which is estimated at the time of contract.
- For Ex.: For Infosys, the large deal was valued at around $1.7 billion. In this parameter, TCS leads the industry with a high TCV of around $8.2 billion.
4) Gross Utilization:
- Gross Utilization can be understood as the productivity of the employee in an IT Company.
- Generally, employees with the proper experience can bill more work than the freshers.
- For Ex.: Infosys has a gross utilization rate of an employee is 77.6% as of Q1FY23, whereas Cyient reports a gross utilization rate of 83.1%.
5) Financial Metrics:
i) Return on Capital Employed (ROCE):
- It refers to the efficiency of a company in generating profits from the capital employed. Ideally, the higher the ROCE is considered the better.
- For Ex.: TCS outperforms its peers with a ROCE of 66.7%, while Tech Mahindra reports the lowest ROCE of 23.8%.
- P/E acronyms for Price to Earnings ratio which values the company’s stock value relative to its per-share earnings.
- Ideally, the lower the P/E ratio, the better it is.
- For Ex.: Wipro posts the lowest P/E of around 17.8 against the highest P/E of 28.8 of TCS in the list.
iii) EBITDA Margins:
- The Earnings before Interest, Tax, and Depreciation & Amortization (EBITDA) margins showcase the company’s operating profitability besides the cost of interest, tax, and depreciation & amortization.
- Ideally, the higher the EBITDA margins, the better it is.
Factors that are Moats in IT Sector:Factors that are Moats in IT Sector:
1) Strong Brand Name
2) High Operating and Net Profit Margins
3) Good Geographical Distribution
4) Good Mix of Products, Platforms, and Services
5) Increasing Focus on Digitalization
6) Low Attrition Rate, Higher Gross Utilization Rate, and Higher Revenue Per Employee
7) Good Network and Partnerships
8) Present Across Many Verticals
What Should Investors Do:
The above-discussed parameters of the IT Sector are some key factors that an investor should carefully consider before making an investment decision in any IT Stock. Follow due diligence before making any investment decisions.
Disclaimer: The information here is provided for reference purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent are commendation to buy or sell stocks or MF.