Performance and Valuation Prime™ Chart
The PVP chart below reflects the real, economic performance and valuation measures of Cognizant Technology Solutions Corporation (NASDAQ:CTSH) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
The four panels explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.
The apostrophe after ROA', Asset', V/A', and V/E' is the symbol for "prime" which means "adjusted." These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liability, and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here.
CTSH has seen historically robust, relatively stable profitability, with Adjusted ROA (ROA') levels ranging from 32%-42% since 2000. Meanwhile, Adjusted Asset (Asset') growth was fairly aggressive from 2000-2008, ranging from 39%-69%, but has tapered off to 2%-31% levels since 2009.
Performance Drivers - Sales, Margins, and Turns
It can be helpful to break down ROA' into its DuPont formula parts, Adjusted Earnings Margin (Earnings' Margin) and Adjusted Asset Turnover (Asset' Turns), which are the cleaned up margins and turns metrics used to calculate ROA'. The chart below details both Earnings' Margin and Asset' Turns historically, to help us better understand the drivers of the firm's profitability and performance. The detail behind the chart can be found here.
The firm's relatively stable ROA' levels has been driven by trends in both Earnings' Margins and Asset' Turns. Earnings' Margins improved from 12% in 2000 to 14% in 2002, before stabilizing at 14%-15% levels through 2008. While Earnings' Margins subsequently improved to 17% in 2010, they fell back to 15% in 2015. Meanwhile, Asset' Turns declined from a peak of 3.6x in 2000 to a lower 2.1x in 2008, before ranging from 2.4x-2.7x since.
Embedded Expectations Analysis
As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.
CTSH is trading at a 14.9x Adjusted Value-to-Earnings (V/E') ratio, at the lower end of historical levels. At these levels, the market is pricing in expectations for a declining ROA', from 41% in 2015 to 25% in 2020, accompanied by 10%-15% Asset' growth.
Analyst and Management Expectations and Alignment
Analysts have bullish expectations relative to the market, expecting ROA' to remain relatively level, ranging from 39% this year to 43% in 2017, accompanied by 4% Asset' growth before potentially rising.
Our qualitative analysis of the firm's Q2 2016 earnings call highlights that management appears concerned about the sustainability of revenue growth and reduced attrition rates. Additionally, they appear concerned about the sustainability of demand for their solutions and the potential of their life sciences segment. Based on these concerns, the market may have reasons for low expectations currently even as analysts are expecting better profitability.
A major benefit of adjusting as-reported financial statements is to clear away accounting distortions, to allow for more accurate peer-to-peer comparisons. To this end we have included a scatter chart below, that plots CTSH against its peers based on their Adjusted Value-to-Assets ratio (V/A') and ROA'.
Looking across industries, across markets and across time, there is a very strong relationship between a company's ROA' relative to the corporate average (6%) ROA', and the multiple the market will pay above the company's book adjusted Asset' base, in terms of Adjusted Enterprise Value relative to Assets (V/A' or Value to Assets'). A company that generates a 6% ROA' will tend to trade at a 1.0x V/A'. A company that generates a 18% ROA' will trade at a 3.0x V/A'.
As we can see above, the market appears to be pricing CTSH appropriately based on its ROA'. There appears to be a trend of higher ROA' warranting higher V/A' among peers. While Accenture (NYSE:ACN) has a slightly higher ROA', it also trades at a slightly richer valuation. Meanwhile, for the same valuation level, International Business Machines (NYSE:IBM) delivers slightly less robust ROA' levels. Based on this view alone, it would appear that Infosys (NASDAQ:INFY) is undervalued, as it trades a slightly less expensive valuation for more robust ROA' levels.
However, the market is not taking into account CTSH's much more aggressive growth rate. In the above chart, we've added each company's 5-year projected Asset' growth rate going forward, in table form at the side of the chart. At 13.4%, CTSH is growing at more than 2x the rate of its strongest growing competitors. While both ACN and INFY have higher ROA's, they have less than half the future growth rate. Moreover, another competitor, IBM, which trades at similar valuation levels for weaker ROA's, is expected to see material Asset' shrinkage in the coming years.
Considering CTSH's ability to have peer-average ROA', but also have substantially stronger growth than peers, likely potentially even taking market share, trading at peer-average V/E' and V/A' in line with other peers levels (adjusted for ROA'), market expectations may be too pessimistic for the company.
Valuation Matrix - ROA' and Asset' Growth as Drivers of Valuation
When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for CTSH at various levels of profitability (in terms of ROA') and growth (Asset' growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red. To see more about the below chart, and also to be able to input your own scenarios to understand how it impacts valuations, please click here.
To justify current prices, CTSH would need to see ROA' fall to record lows at just 25%, well below their historical low of 32%, accompanied by 13% Asset' growth, which would be near historical lows for the firm. If the firm were to see ROA' fall to historical lows of 32%, accompanied by the aforementioned historically low Asset' growth levels, equity upside would be material.
However, considering management's concerns about the sustainability of revenue growth and demand for their solutions, near-term equity upside may be limited. That said, considering low market expectations for the company relative to peers or relative to the company's historical execution, there may be longer-term equity upside.
To find out more about Cognizant Technology Solutions Corp. and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Caroline Cervillon. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.