Cognizant Technology Solutions Corporation (CTSH) is a leading provider of information technology, consulting, and business process outsourcing services in Asia, Europe, and North America. A Teaneck, New Jersey-based company serves a diversified portfolio of clients in the financial, healthcare, retail, manufacturing, and logistics industries. As a result of its high-quality consultative approach and extensive customer partnerships, the company showed an outstanding performance in terms of revenues as well as profits.
As of August 30, Cognizant stock was trading at $62 with a 52-week range of $53.54-83.48. It has a market cap of $19.1 billion. Trailing 12 month P/E ratio is 23.8 and forward P/E ratio is 18.4. P/B, P/S, and P/CF ratios stand at 4.8, 3.6, and 22, respectively. The three-year annualized revenue and EPS growth stand at 29.10% and 27.30%, respectively. Operating margin is 18.70% and net profit margin is 15.4%. Cognizant does not have a dividend policy.
Cognizant has a three-star rating from Morningstar. While its trailing P/E ratio is 23.8, it has a five-year average P/E ratio of 29.6. Out of 28 analysts covering the company, 19 have buy, three have outperform, and six have hold ratings. Wall Street has close-range opinions on Cognizant’s future. The bottom line is 13.9% growth and the top-line growth estimate is 33.1%. Average five-year annualized growth forecast estimate is 20.9%.
What is the fair value of Cognizant given the forecast estimates? In this article, the 15th in a long series, I will show a step-by-step calculation of Cognizant’s fair value using discounted earnings plus equity model.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.
Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $2.66 along with the mean estimate of $3.39 for the next year.
E0 = EPS = ($2.66 + $3.39) / 2 = $3.025
Wall Street holds diversified opinions on Cognizant’s future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 20.9%. Book value per share is $13.01.
The rest is as follows:
Fair Value Estimator
Fair Value Range
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5 year discounted-earnings-plus-book-value model, the fair-value range for Cognizant is between $64.87 and $77.88 per share.
As of Aug 30th, Cognizant was trading at a price of $62. I like Cognizant as a company. Cognizant is a member of the S&P, the Forbes Global 2000, the Fortune 500, and the NASDAQ-100. The company is ranked among the top performing and fastest growing companies in the world. I see great growth potential, as well. The market has under-priced Cognizant’s growth potential. The current price of $62 indicates the stock is undervalued. Based on my FED+ fair value estimate, Cognizant is 25% cheaper than my fair-value range. The stock has to rise by 25% to be fairly-priced.
O – Metrix Confirmation
If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:
O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5
- Dividend Yield: Higher is better.
- EPS Growth: Higher is better.
- P/E Ratio: Lower is better.
The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far.
What is the O-Metrix Score?
- Cognizant does not have a dividend policy. Therefore, the yield is 0.
- Growth estimate is the same as the discounted earnings model and is equal to 20.9%.
- Since we are at the middle of the year, taking the average of ttm (23.8) and forward (18.4) P/E ratios will smooth the results. Thus, the average P/E ratio to be used in the model is 21.1.
O-Metrix = [(20.9 + 0) / (21.1] * 5 = 4.95
Depending on the benchmark chosen, the market has an O-Metrix score range between 4 and 5. Cognizant's O-Metrix score of 4.95 is on upper-end of the fair-value range. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. At a price of $62, the company is trading within the C-Grade, on-average-return zone.
Cognizant’s stock has always been priced at a premium due to its high growth potential. The average P/E ratio in the last five years was 29.6. The stock has debt to equity ratio of 0 and beta of 1.11. The stock has a relatively high PEG ratio of 1.17. It is trading with a slightly high P/E ratio of 23.8, and a forward P/E ratio of 18.4. In the last five years annualized EPS growth was 33.2%.
As of Aug 30, Cognizant was trading at $62, lower than my fair-value range of $64.87 - $77.88. Analysts mean target price of $82.64 is a little more than the upper end of my fair-value estimate. Trailing twelve month ROA ratio of 19.04 and ROE ratio of 23.63 are well-above the market. The stock lost 16% in the last quarter. It is trading 25% lower than 52-week high. I think the current price offers an entry point below its fair value range.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.