How to Analyse IT Sector Companies and Identify Investment Opportunities

Hello, I am Umesh Tripathi, and we are going to learn how to analyze investable companies when it comes to the IT sector. 
We will know what the IT sector is all about, what are the key metrics used in the IT sector analysis, what are the risks, challenges, and cyber security threats associated when analyzing the IT sector, and how to analyze the overall IT sector companies. 

IT sector companies are the companies which basically provide services like software development, system integration, data analytics, cloud computing, big data, and other IT-enabled services. Here, if we take examples of some IT companies, there are companies like TCS, Infosys, Birlsoft  so these types of companies belong to the IT sector, but their focus areas may be different. So whenever we are analyzing the stocks of the IT sector, there are some important things we need to keep in mind, and we also have to analyze important financial ratios. When it comes to the overall IT industry, it’s basically a backbone of the digital economy, because not only does it generate high export revenue, but it is overall a major contributor to GDP as well. As far as global standings are concerned, India holds around 55% of the global IT and BPPPM sourcing market according to NASSCOM, and its exports revenue for the year FY 2024 has been around 190 billion. 

As far as the features of the overall IT sector are concerned, since the talent pool here is very large, it is highly cost-effective. 
Along with this, here we get high profit margins of 20 to 25%. Since there are long-term contracts between clients and companies, due to the recurring revenue model, companies generate consistent revenue through certain clients. Along with this, rapid adoption of artificial intelligence, big data, cloud computing, and digital transformation is a key to success for IT companies. 

Here, let’s look at some key metrics which we use during the analysis of IT companies. 
Here our strong focus remains on revenue growth. Along with that, the EBIT margin  earnings before interest and taxes margin which is related to operating profit, also remains in focus. And Return on Equity is the key factor which we focus on while analyzing IT sector companies. So here, basically, for revenue growth, we focus on how year-on-year revenue increases are happening for companies; along with that, we focus on how much operating profit the companies are generating against revenues; and we focus on how much net income the company is generating against equity, and how efficiently it is being generated. 

Along with this, client metrics is an important metric, where we see how the total clients of companies are providing revenues. 
Attrition rate is another important metric when it comes to the analysis of IT companies. 
In attrition rate, we basically see what the employee exit percentage is for that particular company we are analyzing lower is actually better. Here, as an example, Infosys had an employee exit rate of 12.2% in FY 2024. 

Along with this, Price to Earnings ratio, which is a common metric across different sectors, is an important metric when we are analyzing IT companies. Along with this, there are different risks and challenges and the threats that have to be addressed when it comes to analyzing IT companies. Here, we have already seen attrition risk. If the attrition risk of an IT company is peaking, then that can be a slightly concerning factor. For example, Wipro’s attrition rate was around 23% in FY 2022. 

Along with this, currency risk is also an important challenge for IT companies, because most of the IT companies provide services and earn in dollars. So basically, their revenue is in US dollars, but their cost the costing part is in Indian rupees. 
So here, even if there is a 1% depreciation in the INR, it can boost margins by about 30 basis points. 

Let’s take an example to understand how IT companies are basically impacted by currency risk. So here, let’s assume a company ABC whose US dollar revenue has been $1 lakh. The INR cost here is around ₹75 lakh Indian. Initial exchange rates here were ₹75 for 1 US dollar. So let’s talk about Scenario One. In Scenario One, our INR which was $1 equivalent to ₹75 has now depreciated. 
Now that has become ₹80 per dollar. Here, the revenue is now $1 lakh × by 80, which becomes ₹80 lakh Indian. 
Now, talking about profit here: revenue ₹80 lakh minus the cost which is ₹75 lakh. Now, the profit in this case is ₹5 lakh INR, i.e., Indian. The company now has a higher profit due to the depreciation of the INR. Since the INR has depreciated against the dollar, the company is making higher profit. Now let’s talk about Scenario Two. In Scenario Two, what happens is INR appreciates to ₹70 per US dollar. Earlier it was ₹75; now in Scenario Two it has become ₹70 per US dollar. Revenue in this case becomes now ₹70 lakh Indian, and the profit here is negative ₹5 lakh, i.e., the company which was generating profit in INR depreciation against the US dollar is now making a loss of about ₹5 lakh Indian in INR appreciation. So currency risk is an important factor when it comes to overall IT company analysis. Along with this, tech obsolescence is also an important factor. Companies in the IT sector basically work on certain technology, right? If we pay attention, ten years ago they were working on different technologies. In today’s time, the demand is for artificial intelligence, big data, and cloud computing. 

So in such a case, gradually, as technologies evolve, technologies also keep getting obsolete. So IT companies actually need to focus on and invest in new technologies like artificial intelligence and cloud. So this is also an important factor when it comes to assessing risk in analyzing IT sector companies. Along with this, cyber security threats is a major challenge for IT companies. 
Average data breach cost in India, according to IBM 2023 reports, has been ₹17.9 crore. 
Mostly, sensitive companies like BFSI i.e., Banking, Financial Services and Insurance companies face the higher threat levels when it comes to cyber security threats. Along with this, regulatory and geopolitical risks are associated with IT companies. 
Many times in several instances we have seen that because of certain visa laws and data localization laws, IT companies are mostly impacted. 

Now let’s talk about how to analyze IT companies. Basically, the first and one of the important steps is to look at the business model of the IT company. Mostly, the categorization of these IT companies forms the basis on which we have to do the analysis. 
Whether it is IT services, or a software products company, or platform-based businesses, or consulting and digital transformation related businesses what IT companies are doing, which category they belong to it is important for us to study this. 

So, talking about IT services, a few examples are like TCS or Infosys; If we talk about software products, examples are like Freshworks; If we talk about platform-based businesses, examples are like Salesforce, Microsoft Azure; If we talk about consulting and digital transformation, here companies are like Ascer, Wipro so these are companies belonging to the IT sector, but they are working in different categories and providing services to their clients. So when it comes to the overall business assessment of the IT company, we have to look at the revenue sources whether it is a services IT company or a product-based IT company. 
We also have to study the details of their domestic and international clients. And whether the company is generating project-based revenue or generating recurring revenues which kind of model it is working on we have to study that as well, okay? 

Along with this, industry trends and sector tailwinds these are very important when we are analyzing IT sector companies. 
So, tailwinds basically means the decisions, reasons, and the political events that are considered useful to the business model and overall performance. So we have to check the overall industry trends as far as the IT sector is concerned. Digital transformation spending, cloud adoption, artificial intelligence, machine learning integration, outsourcing, and cyber security demand analyzing all of these becomes important for us. 

Along with this, checking important metrics is very important for us when it comes to IT companies analysis. 
Here, some important metrics are like revenue growth, EBIT margin that is, earnings before interest and taxes Return on Equity, Return on Capital Employed  evergreen metrics across different sectors which we must check. 
Along with this, attrition rate when it comes to IT sector companies is an important metric, and Days Sales Outstanding. 
Days Sales Outstanding means DSO, which is efficiency in collecting the payments from the clients or customers  this is another important metric when it comes to IT sector company analysis, okay? 

Along with this, client matrices  analyzing the client matrices of IT companies is very important. 
What is the top client concentration of that particular company? It should not be overly reliant on one or two clients. If the company has only one or two clients, then in such a case it is called a weak IT company. Assume the company has 10 clients, but it remains dependent on only one or two clients to generate revenue if it is generating 75–80–90% of revenue from just one or two clients even that is a negative point. And repeat business matters for IT companies. So repeat business is an indicator of the strong relationship with the client. So if the company is working with a client on a recurring-based model or on a business repeat model where recurring revenues are being generated, this is a good sign for an IT company. Here, we also have to analyze geographic exposure. We basically have to monitor macro risks. Okay? 

Along with this, in IT companies we mostly have to assess technological capabilities whenever we are analyzing IT companies. 
For example, if we are analyzing a certain company ABC and we see that it is still highly reliant on such a technology to generate its revenue which will become obsolete in a year or so, then investing in such companies can be a bit risky. 
So basically, we should evaluate the technological capabilities of the company  mostly around cloud, data analytics, artificial intelligence, automation, cyber security. 
We should also check the number of patents filed and patents owned by the IT company and R&D expenditures as well. 

Along with this, management quality and strategy of the company is an important factor. We should analyze their capital allocation policy basically buybacks or dividends. And we should also evaluate what the track record is of overall execution of the projects or services. Now here, let’s discuss some important valuation metrics. 
So here, basically, Price to Earnings ratio, EV to EBITDA ratio, and PEG ratio are the important valuation metrics when it comes to the analysis or evaluation of IT companies. So here, look at an example: a peer comparison of TCS, Infosys, and Tech Mahindra. Price to Earnings ratio TCS is 28x, Infosys is 24x, Tech Mahindra 22x. EV to EBITDA ratio  here TCS 20x, Infosys 18x, Tech Mahindra 16x. PEG ratio  here TCS is 1.8, Infosys is 1.6, and Tech Mahindra is 1.5. So from valuations, basically we can analyze the peers and figure out which among the certain companies we are analyzing is undervalued comparatively. Okay? 
So overall, a checklist for IT companies' analysis can be based on revenue growth, based on profitability margins, based on attrition rates, and overall valuation metrics. So here, revenue growth should be at least 10% or more; Operating margin 20% or more, mostly for large caps; Return on Equity and Return on Capital Employed 20% or more; Client diversification no more than 20% of revenue from the top client; Talking about attrition rate attrition rate should be less than 15%; Along with this, talking about R&D and innovation the company should be actively investing in the new technologies; And talking about valuation it should be fairly valued amongst the peers that we are comparing. 

So, all in all, the Indian IT sector is globally competitive, has high margins, and is mostly export-driven. 
Investable companies should have strong fundamentals, low attrition rate, and efficient capital allocation with a strong order book. 

So that’s all in this video. 
See you in the next video. 

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