IT sector valuation premium over Sensex at highest level in over a decade

BSE IT Index trading at P/E multiple of 34.3x - nearly 29% higher than that of Sensex

India’s leading information technology (IT) services companies, such as Tata Consultancy Services, Infosys, Wipro, and HCL Technologies, among others, are the flavor of the season on D-Street. The IT industry valuation premium over the broader market is now at its highest level in more than a decade as investors continue to accumulate the shares of top IT companies and go underweight on at-risk sectors, such as banking, oil and gas, metals, and even fast-moving consumer goods companies (FMCG). 

The BSE IT Index is currently trading at a trailing price-to-earnings (P/E) multiple of 34.3x — nearly 29 per cent higher than the benchmark BSE Sensex P/E multiple of 26.6x. In contrast, till six months ago, the IT index was trading at a discount to the benchmark index. This is the first time in five years that the IT index valuations are higher than the benchmark index’s. The IT sector had last traded at a premium valuation for nearly two years between the middle of 2013 and 2015. The IT sector premium then over the market averaged around 12.5 per cent.  

The industry has since seen a sharp rerating in its valuations in the past one and a half years. The BSE IT Index’s current P/E multiple — more than twice at the end of March 2020’s (15.9x) — is up nearly 30 per cent, from 26.3x at the end of December 2020.

The IT industry’s current valuation is also at its highest level in over a decade. The BSE IT Index’s current P/E multiple of 34.3x is nearly 70 per cent higher than its 10-year average earnings multiple of 20.1x. Analysts attribute the valuation premium and record-high valuation to the industry’s superior earnings outlook. “IT companies are expected to top the revenue and profit growth charts for the next two years. This means most long-term investors are overweight on the sector,” says Shailendra Kumar, chief investment officer, Narnolia Securities.

In comparison, there is a lot of uncertainty about the future earnings trajectory of other key sectors, such as banks, metals and mining, oil and gas, FMCG, and automotive due to factors like rise in interest rate and higher inflation.

Analysts see the premium to stay awhile, given the structural changes to the global economy due to the Covid-19 pandemic.

“The IT industry is seeing a tailwind of strong growth as businesses digitise their operations to deal with the prevalent operating environment. This has created strong earnings visibility for the IT sector —something amiss in other leading sectors of the market,” says Dhananjay Sinha, managing director (MD) and chief strategist, JM Financial Institutional Equities.

Others, however, find the industry’s current valuation and its premium unjustified.

“It’s tough to justify the industry’s current valuation, given the single-digit growth in dollar terms and the likelihood of a decline in the industry’s margins. Last year, the industry’s earnings got a leg-up from a decline in employee and overhead costs due to work from home. This will now reverse, leading to higher operating costs and lower margins,” says Chokkalingam G, founder and MD, Equinomics Research & Advisory.

There has been a sharp rise in employee attrition in the industry in recent quarters, resulting in higher employee costs going forward, hitting margins and earnings growth. This calls for some caution, given the industry’s record-high valuation and a weakness in the broader market.