Value-oriented investors must train themselves to recognize undervalued businesses even when the business does not appear on the surface to be cheap. Business valuation is much more about what a business can and will accomplish in the future as it is about what they have accomplished in the past. Investment risk comes into play due to the fact that nobody can truly predict the future with absolute certainty.
Even though there are no guarantees regarding the future share price of any business, we can certainly mitigate our risk through effective due diligence. A significant part of the due diligence process is to ensure that less than obvious opportunities are not overlooked due to our preconceived perceptions regarding fair value calculations. Part of that due diligence requires that we consider our expected rate of return on our investment capital rather than just simply looking at the current valuations. In other words, we must be cognizant of the fact that high growth expectations can justify above average current valuations and still qualify for the portfolio of a serious value investor.
How Does A Business Justify Premium Pricing?
There are certain characteristics that endow a business with inherent value. One of those traits is being able to provide its clients with a product or service that is necessary to their business operations and difficult to remove once it becomes embedded. This gives them the ability to keep constant upward pressure on prices without losing existing customers. If the products and services fall within an area that requires sophisticated technical expertise in which to operate, it becomes even easier to assign a premium value.
Investors who take the time today to acquaint themselves with the business fundamentals and characteristics of Cognizant Technology Solutions (NASDAQ:CTSH) will be in a position to enter into an investment that should reward them with 15% to 20% annual gains for the foreseeable future. They will also quickly come to realize that what, on the surface might appear to be a high-priced growth stock with the normal risks associated with such an investment is really more of a value investment that simply has and will continue to grow at a very rapid pace.
What Makes Cognizant Special And Why Now?
Cognizant Solutions is an IT consulting and outsourcing firm that assists its clients in improving the effectiveness and efficiency of their business operations. The business operates across four distinct areas of specialized expertise in the areas of financial services, healthcare, manufacturing and retail and logistics. Providing vital IT maintenance and solutions to businesses with complex needs from the IT functions places Cognizant in a very unique position within the day-to-day functionality of its clients' business operations and in a position where it is very difficult to change suppliers without serious disruption to the flow of normal activities. In layman's terms, once Cognizant embeds itself into its clients' business operations, it becomes horribly expensive to change service providers. As long as they do their job, there is little reason for a customer to change and big reasons not to even consider it.
Businesses like Cognizant can leverage their unique value by offering an ever expanding line of products and services to its customers who, in many cases are completely dependent upon reliance on the recommendations from the supplier when it comes to deciding what they actually need and the benefits it will provide. This is exactly the kind of repetitive and almost addictive products that investors should dream about finding a business supplying. The more their customers consume, the more they need.
Why does the opportunity exist now? At first glance, Cognizant does not appear to be priced cheaply. It is currently trading at 20.51 times estimated 2014 earnings and 20 times free cash flow. These are not bargain basement type numbers that value investors tend to seek, or are they? Maybe not if you are simply looking at the present. But, if you take the time to look forward while considering the business model, then you will see the real value in this business at today's price.
First of all, the company has $5.836 billion in cash and receivables on its books and just $1.656 billion of total liabilities leaving net cash after all liabilities of almost $7/share or 13% of the market value of the entire business.
Against 2015 consensus earnings, the company's P/E ratio shrinks to a 17.4 times multiple. With a projected 5-year annual earnings growth rate of 17.4%, the business is actually trading at a multiple of only 1 times the expected annual growth rate. But, we must decide if the growth rate is realistic. The best source available for that evaluation is what the business has accomplished recently. Since the past 10 years includes some of the worst business conditions since the Great Depression as part of the period, the past might give us a fair view of what to expect in the future.
Over the past 5 years, Cognizant has delivered average annual returns on equity, assets and capital of 23.3%, 17.8% and 23.3% respectively. One of my calculations for establishing an estimated fair value of a business is to average these three numbers and multiply the result by the current year's projected earnings figure. The resulting average of these three measures of performance is 21.467 and, if multiplied by the current year's projected earnings of $2.41 produces a current fair value estimate of $51.73/share with an increase to $59.25/share within the next 12 months. This represents an expected return of 19.8% from the current price of $49.44.
However, long-term investors need to look further out than just 12 months to assess the real potential of a business. Analysts covering the stock currently project it to expand earnings at the rate of 17.4%/year for the next 5 years. I completely understand those who will believe these estimates are on the optimistic side. I thought the same thing until I realized that between 2004 and 2013 the company increased its sales from $586.67 million to an astounding $8.84 billion and per share earnings from a paltry $0.18/share to $2.05/share with a projection to grow another 18% this year. Considering the past history of performance, 17% a year going forward suddenly looks much more believable.
Accept Value Where We Find It And Act
Value does not always have to be a stock that looks cheap by my traditional valuation measures. Good investments are made by selecting those stocks that are cheap compared to the realistic future expectations of the business. Stocks with the past history and future prospects of a business like Cognizant can easily be valued at twice the expected growth rate multiplied by the current year earnings. It is quite unusual to find one trading at a multiple of 1. When the projected growth rate is 17%/year and all that is required to collect that level of return on capital is to maintain the current and fair multiple, investors who can set aside preconceived notions of "value" and act will collect excessive returns even without improving valuations.
As I always prefer having multiple attractive ways to open new positions, I am pleased that Cognizant offers that opportunity as well. For those who prefer the traditional approach of buy and hold, shares can be purchased at the market today and held until the market assigns a P/E multiple to the shares of 24 or greater.
Investors who simply insist on getting discount prices for everything they buy can sell (1) August 16, 2014, $47.50 strike price put option for each 100 shares they wish to purchase and collect a premium of about $0.75/share or 1.5% of the capital required to purchase the shares. This represents an annualized return on total capital of 20.49% and would require the seller to purchase 100 shares of the stock for each option sold at a price of $47.50 each or $4,750 per contract sold. Should the seller be assigned the shares on August 16th, the purchase price would represent a discount of 3.9% to the current market price.
Investors who find the current price compelling and wish to buy now; but, who would also like something a little extra thrown in, can consider buying the shares outright and simultaneously selling (1) August 16, 2014 expiration call options with a strike price of $52.50 for each 100 shares of the stock that were purchased for a premium of about $0.45/share. The sale of these options would result in an immediate return on capital of 0.91% for an annualized rate of return equal to 12.3%. Should the shares rise to a level above $52.50 by August 16th, the stock would be called away by the option buyer and the seller would achieve an additional $3.06/share (6%) in short-term capital gains. This scenario would produce a total gain of $3.06 + $0.45 or $3.51 against the $49.44 purchase price of the stock for a total gain of 7.099% over the 27 days covered by the trade for an annualized return on capital allocated equal to 95.9%.
So, we have an excellent business with a great history of superior results. We have an attractive valuation based on present facts and future prospects and three superb ways to open a new position. Is there anything else needed in order to motivate investors to take action now? There shouldn't be.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.