Valuation Doc Final

8/8/2019 Valuation Doc Final

1/12

HCL Valuation

DCF Valuation:

This method consists of 4 steps:

Step 1Forecast Expected Cash Flow: This is done based on assumptions regarding the company's revenuegrowth rate, net operating profit margin, income tax rate, fixed investment requirement, and incrementa

working capital requirement.

Step 2Estimate the Discount Rate:Weighted average cost of capital (WACC) is the discount rate that's

used in the valuation process in order to bring the future cash flow values to present value. It is based on th

concepts ofCost of Debt and Cost of Equity.

Step 3Calculate the Value of the Corporation:Enterprise Value of a company is the sum of all the

discounted cash flows and its discounted terminal value. Terminal value is to value the company as a

perpetuity using the Gordon Growth Model.

Step 4Calculate Intrinsic Stock Value: We then subtract the values of the company's liabilitiesdebt

and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock

outstanding to get the intrinsic stock value per share.

STEP 1: Forecasting Free Cash Flows

A company generates revenue by selling its products and services to another party. In generating revenue,

company incurs operating expenses. To produce revenue a firm not only incurs operating expenses, but i

must invest money in real estate, buildings and equipment, and in working capital to support its busines

activities. Also, the corporation must pay income taxes on its earnings. The amount of cash that's left over

after the payment of these investments and taxes is known asFree Cash Flow to the Firm (FCFF).It is an

important measure to stockholders as it is the hard cash that is available to pay the company's various clai

holders, especially the stockholders.

Sales Revenue - Operating Costs Taxes = NOPLAT (Net Adjusted Profit less Adjusted tax

or Cash flow)

NOPLAT+ Depreciation- Net Investment- Change in Working Capital= Free Cash Flow


2/12

Future Revenue Growth:

In order to predict the future revenues of Infosys, we have estimated the future revenues it would generat

through its Service lines and Geographies. In present scenario where sovereign risk is a major threat focusing

on geographies is quintessential for IT companies such that they are not impacted due to concentration risk

Revenues a company would generate through service lines would depend on the growth that each of these

sectors would have in future and its impact on generating top line for IT industries.

In case of geographies, HCL has its footprint in US and Europe as major markets contributing to an averag

of 57% and 28% respectively to its overall revenues.

CAGR of past 5 years Growth rate taken by us

US 28% 28.2%

Europe 31% 9.5%

Rest of the world 27% 33.5%

We have used the Weighted average method and Unitary method in order to project these growth rates.

Weights have been assigned as per the cause-effect relationship it would have over companys growth.

Weights

assigned

0.4 0.4 0.1 0.1

Factors

Influencing

CAGR of HCLs

revenue in each

geography

CAGR of

Indian exports

in IT sector

CAGR of

TCS(Market

leader)

CAGR of

Infosys(Competitor)

US Factors

Weights

Assigned 2006 2010 CAGR

Weighted

CAGR

Total IT services export 40% 24 50 19.95% 7.98%

HCL Revenue from US 40% 2743 7413 28.22% 11.29%

Infosys 10% 9521 22742 24.32% 2.43%

TCS 10% 12396 29085 23.76% 2.38%

24.53%


3/12

Europe Factors

Weights

Assigned 2006 2010 CAGR Column1



Infosys 10% 9521 22742 24.32% 2.43%

TCS 10% 12396 29085 23.76% 2.38%

24.99%

Rest of the world Factors

Weights

Assigned 2006 2010 CAGR Column1



Infosys 10% 9521 22742 24.32% 2.43%

TCS 10% 12396 29085 23.76% 2.38%

24.37%

Unitary Method for Final

Expected Growth US Europe

Rest of the

world

Economies Current Growth Rate 2.70% 3.70% 3.10%

Expected Growth Rate of Economy 3.10% 1.40% 4.20%

Weighted CAGR of the company 24.53% 24.99% 24.37%

Expected CAGR of the company 28.16% 9.46% 33.02%

In case of service lines, we have assumed that each service line would grow at the rate of its CAGR for the

next 5 years with BPO service line as an exception. The BPO sector is expected to grow at rate of 31.4%

(including the BPO sector growing within the country). HCL did recently acquire UK based liberate Financial

Services and US-based Control Point Solutions in its line with VBPO strategy. Considering these factors and

taking into account the CAGR (13%) of the company for the BPO sector we have projected the growth rate

for this sector 15% for the next 5years. By taking an average of revenues generated through service lines and

revenues generated through geographies, the future estimated revenues could be calculated.

BPO growth Rate 10% 31%

HCL BPO CAGR 90% 13%

Expected growth rate for BPO 15%


4/12

We considered the CAGR of the other service lines inclusive of Custom Applications, Infrastructure Services,

Enterprise Services and Engineering and R&D services as the expected growth rate.(Refer to limitations).

This gives us different expected revenue for each of the coming five years under Geography and Service Line.

Then we calculated the total expected revenue for each year. Average of both the revenues gives us the

expected revenue for HCL technologies in the each of the coming five years.

Estimated Revenues of HCL for forecasted period

2011E 2012E 2013E 2014E 2015E

Estimated revenues

through Service lines

16551 19374 23606 29695 37416

Estimated revenues

through geographies

15567 19387 24259 30490 38472

Estimated

revenues(average)

16059 19381 23933 30093 37944

Future Operating Costs:

One needs to look at the company's historic operating cost margins to forecast the future operating costs. The

operating margin is operating costs expressed as a proportion of revenues.

Over the past five years, HCL has generated an average operating margin of85.19% which means for every

one rupee of revenue, company incurs 0.85 rupee in operating costs. Company has been incurring hig

operating costs over past 3 years due to its expenses as its in the growth stage currently and has to spend o

its R&D, S&GA expenses etc. However, average operating margin can be used to forecast the operating costs

in next 5years. We have considered the impact of Visa Hike Cost at this level which would eat away th

companys bottom line by a substantial amount.

Visa Hike: The recent policy change in US visa fee will have significant impact on future revenue forecast.

Thus ignorance such a high risk would not give us the real picture. To take into account this factor we have

considered the fee hike of $2000 to remain the constant for the next five years.

We have assumed onshore: offshore component as 1:9(industry standard). We have considered a direc

correlation between the revenue from US and number of employees working in the US project. The tota

number of employees thus calculated is 60% of the total work force. The foreign exchange rate for USD/ INR

has been assumed at 46.This has been multiplied with the total number of employees to find the expecte

increase in cost because of Visa hike.


5/12

Per employee

increase* 92000 92000 92000 92000 92000

No.ofEmployees ** 3600 4068 4597 5194 5870

Total cost in rs. 331200000 374256000 422909280 477887486 540012860

Total cost Rs. In crore 33 37 42 48 54

Taxation:

A firm's income tax rate is equal to the provision for income taxes divided by the firm's operating incom

before provision for taxes (EBIT). EBIT can be calculated by subtracting operating costs from revenues and

thus we can reach at a value of EBIT for the next five years. This value when multiplied with tax rate gives

the estimated tax that company would pay. HCL has an average income tax rate of13.43% over previous

5years. Comparing this against Infosys which also had an average tax rate of 13% past 5 years, we have

assumed this average rate as the effective tax rate that would be paid by the company for the forecasted

period.

At this stage NOPLAT is derived which is the cash flow of the company.

Depreciation:

The company is on a high growth stage. It keeps increasing with the increasing revenue as it would continue

expanding. Thus we calculated deprecation as percentage of the revenue for the last five years which is around

25% which is expected to continue in the coming three years also. Then we took the same for the past two

years and future three years to come out for the next two years depreciation ( as it would increase further) at

27%.

Net Investment:

Net fixed investment rate is equal to the company's new investment in plant, property and equipment (PP&E).

To calculate this ratio, one needs to know the company's investment rate, equal to the firm's yearly investment

in PP&E divided by revenues. There is constant decline that can be seen in net investment rate over the past 3

years however HCL will almost certainly have to boost capital investment to stay ahead. So, we will assume

that net investment will steadily return to its average level of 7% of sales over the next five years.

Change in working capital:

HCl is a well managed company with efficient working capital management. We assume that the compan

would continue to manage its working capital in an efficient manner for the coming years as in the past. We

have taken working capital as a percentage of revenue which is around 18%.


6/12

Free Cash Flow forecast calculation

2011 E 2012 E 2013 E 2014 E 2015 E

Revenues 16059 19381 23933 30093 37944

Op costs 85% 13681 16413 20100 26153 32962

(% of revenue)

Visa Hike

Cost 33 37 42 48 54

EBIT 2345 2930 3791 3891 4928

Tax 13% 315 393 509 523 662

NOPLAT 2030 2536 3282 3369 4266

Depreciation 25% 625 781 977 1240 1575

Net Inv 7% 1124 1357 1675 2106 2656

Working Capital 18% 2891 3488 4308 5417 6830

Change in WC 554 598 819 1109 1413

Future Cash Flows 977 1363 1763 1394 1772

STEP 2: Calculate WACC

WACC is the sum of Cost of debt and Cost of equity.

Cost of equity can be calculated using CAPM model which states it as follows:

Cost of Equity (CAPM Model) = Rf+ (Rm Rf)

Rf - Risk-Free Rate - The risk-free rate represents the interest on an investor's money that he or

she would expect from an absolutely risk-free investment such as government bonds over a specified

period of time. It is taken as 7% which is the rate of return on a 10 year Government treasury bond in

India.

- Beta - This measures how much a company's share price moves against the market as a whole. A

beta of one, for instance, indicates that the company moves in line with the market. If the beta is in

excess of one, the share is exaggerating the market's movements; less than one means the share is

more stable. Beta of HCL is taken as 0.88 (Source: BSE India).


7/12

(Rm Rf) Equity Market Risk Premium -Stocks should provide a greater return than safeinvestments prevailing in the market like Treasury Bonds. The difference is called the equity risk

premium. It is the excess return that you can expect from the overall market above a risk-free return.

It is taken as 6%. The market premium for the IT industry as per CNX IT for the past four years has

been 13% (CAGR) ( Refer Annexure). We have assumed the risk free return based on the 10 year

treasury yield which is approximately 7%.

Ke = Rf + b(Rm- Rf)

= 7 + (0.88 * 6)

= 12.28%

Cost of debt: We calculated this by dividing total interest paid to the total debt amount. Its debt

quotient has increased to a large amount this year due to bridge loan that it has taken to fund

acquisitions.

Bridge loan Borrowings for equipment financing Other Borrowings Total

Debt amount 2395 64.3 414 2873.3

Effective Interest 5% 8% 9%

Interest 119.75 5.144 37.26 162.154

By dividing the total interest with total debt, we get cost of debt as 5.6%

WACC = 5.6% * 0.38 + 12.28% *0.62

= 9.74%

The proportion of debt and equity of HCL is calculated as 0.38 and 0.62 respectively from their

balance sheet which states the total debt amount and equity capital.

A low WACC indicates that the company acquires capital cheaply. A business with debt usually has a

lower WACC than one without. A low WACC can therefore create more value for the shareholders

out of the projects it chooses to invest in.

STEP 3: Calculate Enterprise Value

Terminal Value: The terminal value is the value of the companys expected cash flow beyond the

explicit forecast horizon. It is the value of company beyond the forecast period. It makes an

assumption that the organization would exist forever. Growth rate of the company in perpetuity would

be the rate at which economy would be growing. This rate has been assumed as 8% as its perceived


8/12

that Indian Economy would grow around or above this rate in times to come. It simplifies the practical

problem of projecting cash flows far into the future. But keep it rests on the big assumption that the

cash flow of the last projected year will stabilize and continue at the same rate forever.

TV of HCL = 1772*1.08/((0.1228-0.08)*(1.09774)^5)

= Rs 28047 crore

Enterprise Value: Enterprise value is the total value of the company. It is derived from the sum of all

discounted cash flows including the terminal value.

2011 E 2012 E 2013 E 2014 E 2015 E

Free Cash Flows 977 1363 1763 1394 1772

Discounted Cash flows 890 1132 1334 961 1113

Total Company value: Rs 33478 crore

STEP 4: Calculating Intrinsic Stock Value

Fair value of equity should be determined which can be attained by deducting debt from the

Enterprise Value.

Debts and liabilities : Rs 6534.1 crore

Fair Value to common equity: Rs 26944 crore

Total Outstanding shares: 67 crore

Share Value As per DCF method: Rs 400.35

Therefore, Expected price of HCL Stock using DCF valuation is Rs 400.35

Relative Valuation:

We can reach at the intrinsic value of the company using DCF and relative valuation method. The

latter helps the investor in deciding whether to invest in a company or not looking at their future

estimates of EPS. It helps an investor to compare across companies and zero in on one which shows

better future estimates.


9/12

2011 2012 2013 2014 2015

Revenues 16059.08 19380.54 23932.97 30092.54 37943.74

Op profit 2344.781 2929.848 3790.77 3891.338 4927.76

(% of rev)

Tax (@15%) 314.904 393.4786 509.1005 522.6067 661.7982

Depreciation625 781.25 976.5625 1240.234 1575.097656

Net profit 2029.877 2536.37 3281.67 3368.731 4265.962

EPS 30.29666 37.85626 48.98015 50.27957 63.67107

P/E(Forward) 12.05 10.59 8.99 9.61 8.34

Share price 400.8184 440.1518 483.345 530.7769 582.8634

Earnings per share are Net profit divided by number of outstanding shares. By deducting tax and

depreciation from operating profit, we get to come down to net profit. These values are derived for

next 5years and when divided with number of outstanding shares (67 crore) gives future estimate of

EPS value for each year respectively.

Looking at the previous share prices and calculating CAGR over 5 years, the value is attained as 10%.Assuming the similar growth rate as CAGR for next 5 years we arrived at the share price values of

HCL. Dividing this market price of each year with corresponding EPS, we derive at the P/E value for

each year respectively.

Expected Stock Price = Rs 400.82

Finally, we have taken an average of both these prices in order to come to an expected price of the

stock.

Expected Stock Price of HCL = (Expected Price using DCF method + Expected Price using Relative

Valuation Method) / 2

= (400.35 + 400.82) / 2

Estimated price = 400.59

As values derived from both the methods have marginal difference, we could avoid triangulation and

rather just take an average of the prices attained in order to smoothen errors if any.


10/12

Comparison between the giant Infosys and the Dark horse HCL

The valuation data for Infosys can be found in the annexure. The valuation of Infosys has been done

on similar line as HCL.The following chart depicts that though Infosys is leading in terms of revenue

but in terms of Y-O-Y growth HCL seems to outperform. Thus we can say that the giant Infosys

needs to pull up its socks as the Dark Horse is catching up very fast.

4572 6069 756310229 12565

1605919381

2393330093

37944

952113893

16690

2169322742

2682831795

39221

48973

61360

0

20000

40000

60000

80000

100000

120000

2006 2007 2008 2009 2010 2011 E 2012 E 2013 E 2014 E 2015 E

Revenue comparison

Infosys

l

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

2006 2007 2008 2009 2010 2011 E 2012 E 2013 E 2014 E 2015 E

Growth Rate

l

Infosys


11/12

Limitations:

Annual report 2009- 2010 given only in US GAAP and not yet in Indian GAAP Information not given about business verticals like the way it was revealed fro geographies

and service lines.

The assignment of weights for the revenue calculation was not done on the basis of anymathematical model. It was mainly based on the experience and assumptions.

The growth rate of economy is completely based on the data from IMF and no other concretedata was available.

The beta was taken directly from Reuters website and no calculation was done. Tax rates were not mentioned in the annual reports. The calculation is done based on the

difference between PBT and PAT as per balance sheet.

The time was obviously one of the most important constraints.

Conclusion:

In the current market scenario, HCL is termed as The Dark Horse which slowly

started gaining prominence and is able to compete in the race of IT sector by increasing its market

share consistently. When every other company saw a fall in the revenue growth, HCL was one of the

companies which could still grow at a decent percentage as its previous years of growth. But one

reason for this could also be the small numbers when it comes to the absolute figures.


12/12

Annexure

1. Infosys Valuation

Average 2006 2007 2008 2009 2010

Revenues 9521 13893 16690 21693 22742

Operating costs 6430 9502 11454 14498 14881

(% of revenue) 67.36% 67.53% 68.39% 68.63% 66.83% 65.43%

Operating Profit 3091 4391 5236 7195 7861

Tax 313 386 685 919 1681

(% of op profit) 13% 10.13% 8.79% 13.08% 12.77% 21.38%

Net Investment 653 996 896 566 -230

(% of revenue) 4.20% 6.86% 7.17% 5.37% 2.61% -1.01%

Working Capital 3988 7371 8827 12774 13782

Change in WC 1499 3383 1456 3947 1008

Market Premium Calculation :

Date Values of CNX IT

As on July 1, 2006 3219

As on June 30, 2010 5250

CAGR 13.01%

Valuation Doc Final

Documents

Transcript of Valuation Doc Final