If returns for the past 12 months are considered, the three firms saw their stock prices rise by 19%, 28% and 36%, respectively. Even the fourth largest software services firm, Wipro, a laggard in terms of earnings compared to the other three, saw shares rise about 10% in the past three months, and 25% over the past 12 months till Friday.
In comparison, the sectoral BSE IT index climbed over 29% in the 12-month period while the Nifty IT index soared over 27%.
Analysts say despite subdued revenue growth across the $250 billion Indian IT industry, valuations are getting a heft from an anticipated revival in demand in key clientele regions – the US and Europe. Expected business revival, deal wins and focus on margin improvement in the past 2-3 quarters has further pushed up the momentum.
The first leg of the sector’s outperformance is largely driving valuation re-rating, says Kumar Rakesh, associate director at BNP Paribas. “As discretionary demand starts recovering in the coming quarters, we expect earnings upgrades to also follow. This could drive the second leg of the sector’s outperformance,” Kumar said.
He added that the price/earnings-to- growth (PEG) ratio for many companies under BNP’s coverage have improved in recent months, trading between 2.0-2.5x. This is slightly above the last five-year average, suggesting IT stocks are expensive currently.
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“As we see earnings upgrades in the coming quarters, we expect the PEG ratio to normalise below 2x,” said Kumar. The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company’s expected growth. As growth – the denominator – expands, the ratio stabilises back to normal.Saurabh Gupta, president of research & advisory services at HFS Research said the PEG ratio for the Indian IT sector increased in recent years due to strong post-pandemic growth but began to moderate in 2023.
“Clients are becoming cautious about discretionary IT spending given macro-economic challenges, which have dampened earnings growth for IT companies. Indian IT companies have been shifting focus from traditional services to high-margin digital services like cloud, AI, cybersecurity, and automation that have helped stabilise PEG ratios for companies that execute this transition well,” he said.
The outsourcing industry has been struggling with low single-digit revenue growth over the past more than five quarters. The rising wage inflation and talent shortages could further adversely impact companies’ margins. This reduces near-term earnings growth, and puts pressure on PEG ratios unless these firms can offset it through AI-driven productivity or other efficiency measures, Gupta said.
However, the first quarter of FY25 highlighted green shoots in the IT industry with strong deal signings, and execution of FY24 deals by most of the top and mid-tier firms, affirming a turnaround this fiscal.
ET reported in August that nearly 700 contracts worth $26 billion were due to be renewed worldwide during August to December for technology services deals. Several new and existing projects are already being signed and won. Besides, the larger firms will start capitalising on some of their returns on GenAI investments.
Sumit Pokharna, vice president at Kotak Securities, said price-to-earnings (PE) multiples have expanded meaningfully in the past year. “Some stocks have crossed the Covid peak in valuation multiples, even as growth is nowhere near the highs of FY2022-23. The margin of safety has reduced after the rally in stocks,” Pokharna said.
He said disproportionate stock price reaction to marginal revenue and earnings beat of IT firms was unanticipated. “We agree with the Street’s ‘bottoming’ out thesis, though we do note that consensus high-single digit revenue growth for large companies and teens for mid-tier names in FY2026E already bake in an improved environment…Indications of better technology and discretionary spending outlook are visible in select firms,” he said.
According to Pokharna, there are visible signs of rebound in tech spending in regional banks and mid-sized BFS (banking and financial services) firms, indicating broad-basing of positive sentiment.
“Continuation of the same can pave the path for spending normalisation in CY25, our base case,” he said.
According to a Nuvama Institutional Equities report, “Despite negativity around the sector and headwinds staring it in the face, Nifty IT as well as most IT stocks have outperformed the index (Nifty 50). As a result, most stocks are trading at a premium to their pre-covid levels. We see this as an indicator of market confidence in the earnings potential of IT services companies, which have continued to report strong deal flows, providing high revenue visibility over the medium-to-long term (FY25 and beyond).”
“We believe PEG is a better option to arrive at the fair PE for IT Services companies given the completely different demand and growth environment in which the sector is currently operating – compared with pre-covid levels,” it said.
