• Software/IT Sector Valuation Methodology

    Software or the IT services companies provide the IT infrastructure or other necessary IT services to different organizations and institutes across the world. All the global IT companies have opened their development centers in the emerging countries likeIndia,China,Brazil, Philippines etc for cheap labors compared to other developed nations and improvement of quality of services. Higher competitiveness among the IT service providers has also prompted them to look for more business innovation and high end IT services to the existing and new customers.

    The sources of revenues are from the clients spread across the globe who are building their new IT infrastructure or upgrading the existing one or maintain the current IT services and infrastructure. A major part of revenue comes from the support and maintenance of the existing IT systems.

    The main expenses are the salaries of the IT professionals working in a particular IT company along with the rent of office space or cost of Land, Cost for different technical trainings etc. All the IT companies need to work on the latest technology and development which come with huge cost.

    Key Terms of Software/IT Sector

    Scalability and Size

    As human resources are the main pillar for IT sector companies, an IT company’s efficiency lies in how it can utilize its employee base to achieve higher scalability and size of work done. An IT company should be able to handle growing amount of work volume with the continuous increase in its employee base.

    Increasing Value Chain or Services Offered

    Companies have to move up in the value chain gradually to increase the quality and delivery strength of services offered to different types of customers. An IT company can start with the basic service but it has to increase its service base and quality to get better and higher valued contracts in future to grow in the IT services business. Moving up in the value chain will help them to get big end-to-end implementation, IT infrastructure development and business transformational deals with the big clients which will create the path for future success. Delivering the ultimate product with highest quality within proper time frame and customer satisfaction are the most important aspects to grow.

    It takes time to move up in the value chain and be eligible to bid for high quality and large contracts. There is a very low barrier for a company to enter into the IT sector which leads to huge competition since the beginning. Failure to move up in the value chain with time can lead an IT company to shut their business.

    Billing Rate

    As we have already told, success of IT industry in the developing countries lies in the cheap billing rate compared to the other developed countries where the billing rate is very high. Cheap billing rate in countries likeIndia,China,Mexico,Philippineshelped them to grow significantly in last couple of decades. IT companies have to use billing rate properly to provide better quality services to the customer at cheaper rate. It should not be too low to affect the deliverables and quality of the end product or services offered. At the same time too high billing rate reduces the chances of getting the contract significantly.

     Employee Utilization

    As the main source of revenue is the workforce, IT companies should improve the utilization of its work force which denotes the efficiency of generating profit by using the human resource employees. It has to utilize its all employees as effectively as possible to increase its revenue and profitability. The utilization capability depends on the key management decisions and the policies of the company.

    Employee Knowledge Base

    The IT or software sector is very much technology intensive sector where new technologies come every day and technology changes and advancement happens very fast. An IT company has to provide adequate trainings to all of its employees to make them capable of handling any new technology which are being used in the market. The knowledge of all the employees has to be updated with time to make them competitive in the market as well. Also more technological innovation and research and development are also key parameter which can drive business in the future.

    Total Hours worked

    As the main income of the IT companies comes from the billing of its personal work force, the total hours worked by all of its employees are used to calculate the revenue generated by the IT services companies. This is applicable only for companies without any product. For product companies the main source of revenue comes from selling of its products.

    Retention and Attrition

    Employees and resources are the main source of income of the IT sector companies, their continuous source of income lies on the retention of its employees. But at the same time due to high competition and high demand of IT skilled workers, employees change company to get more benefits and compensation. The attrition refers to the percentage rate of employees leaving the company within a specific period of time. Higher attrition leads to difficulties to attain continuous business growth.

    Companies always use different HR policies and HR benefits to retain its employees. The main benefits include higher variable pay based on performance and ESOP (Employee Stock Option Plan) to retain its topmost skilled employees. Attrition rate can be an important parameter to judge an IT services company.

    Key Financial and Operational Details

    To evaluate any IT or software company, the analyst should look into the below operational and financial parameters to calculate its financial health and competitive position in the market.

    Management Capability

    The success and competitiveness of an IT company depends on the management capability of the company which drives the whole business. Sometimes the effective leadership of the top management makes an IT company the industry leader while sometimes ineffective leadership can lead to huge failure. The long term vision and business objectives sets by the management are also important parameters considered here which helps to take the proper strategic direction in the future.

    Employee Attrition Rate

    Employee attrition rate, which has already been discussed, is something the analysts check to evaluate a software company. The higher attrition rate, more threat for the company.

    Revenue Concentration

    Another important parameter that the analysts look at is the revenue concentration or the geographical distribution of the revenue source. Too much dependence on one particular geographical location is considered to be more risky for the IT companies. For most of the Indian IT companies, more than 50% revenue comes from US only. Any recession or economic downturn in US can hurt their revenue income and profitability significantly. That’s why IT companies should try to spread their client base and business across the world and financial analysts consider this as an important parameter to evaluate the risk exposure of an IT company.

    Competition

    The billing rates and expansion plans are affected by the competition from both the domestic and big global players. The competitiveness increases with lower entering cost and high number of players in the market. The higher the company grows in the value chain and offer high number of services, the competition becomes lower. High competition often leads to lower billing rate which again leads to lower profitability for the company.

    Operating Profit Margin

    Operating profit margin is the most important financial parameter to judge the financial performance of an IT company. Operating profit is calculated by deducting the operating expenses from the total sales revenue. Operating profit margin is calculated as

    Operating Profit = Net Operating profit/ Sales Revenue

    The higher the operating profit, the better the company able to conduct business with lower operating expenses.

    Some companies give more importance on operating profit margin and try to maintain high operating profit margin along with the growth. Mostly Indian IT companies prefer high operating profit margin within the range of 20% to as high as 30%. At the same time, some companies give low importance on operating profit margin and look for volume growth, like most of the global IT players which keep operating profit margin near to 10% level.

    Net Profit Margin

    Net profit is the cash generated at the end from the business operations. Net profit margin is calculated as

    Net Profit Margin = Net Profit/Sales Revenue

    Net profit margin denotes a company’s capability to generate cash from the normal business operations.

    Top line Growth

    Top line growth is denoted by the growth in the top line numbers or the sales revenue compared to previous quarter or the same quarter previous year.

    Bottom line Growth

    Bottom line growth is denoted by the growth in the bottom line numbers or the net profit compared to previous quarter or the same quarter previous year.

    Key Valuation Parameters

    For IT or Software Companies, “Price to Earnings” or P/E price multiple is used to evaluate the share performance.

    Reasons behind using the P/E Ratio instead of other price multiples

    For an IT company, earnings are very difficult to manipulate like any other sector companies. At the same time, IT companies do not have too much machinery or fixed assets, that’s why they can’t use depreciation to manipulate earnings.

    That’s why P/E Ratio is used to check whether an IT company’s share is undervalued or overvalued compared to other companies from the same peer group. Other profitability ratios like Return on Equity, Return on Assets and Return on Capital employed are also used to evaluate an IT company.

    P/S Ratio is not widely used because of different profit margins used by different IT companies and sales revenue can not actually signify the financial performance of an IT company. A loss making project or assignment can lead to higher revenue but at the same time reduces the total earnings earned. P/BV Ratio is not also widely used for IT services companies as they don’t have significant fixed assets. Their main assets are their employees or technical staffs which are almost impossible to evaluate.

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