Don't Fall Into Cognizant's Value Trap

On Tuesday, Cognizant Technology Solutions (CTSH - commentary - Cramer's Take) traded down more than 19% after issuing revenue guidance slightly below expectations. Although buying a stock posting 50% earnings growth for a multiple in the 30s may appear appealing, doing so could catch you in a value trap.

The Employee Factor

As I have noted elsewhere, Cognizant's labor-intensive business requires adding people in order to add revenue. In fact, the growth in one year's head count has generally closely predicted the following year's growth in revenue. Historically that has not been a problem.

In 2007, however, Cognizant is adding the same absolute number of employees as it did in 2006, about 15,000. But while last year's increase amounted to 60% growth in employees, this year's only amounts to 37.5%. Don't get me wrong, that is still a very impressive number, and the employees have historically been underutilized. Increased utilization can be a good thing.

But what if the 15,000 employees per year is an upward limit? Next year, that would make for just 27% growth, and the year after it would be just 21%. You can see that within a few years, the growth rate would look "normal," and the P/E would have to decline. Then getting a really good return starts to become tough.

Square P/E/G, Round Hole?

I am no fan of the P/E/G ratio, which wrongly assumes that growth and valuation have a linear relationship. But many Cognizant investors seem to put some faith in it, arguing that the P/E multiple is low given how much Cognizant is growing. Looking back, Cognizant's P/E/G has consistently ranged around 1.0, which suggests that investors may truly be using it as a gauge. Whatever my own feelings about the P/E/G's merits, if it drives the stock price, I will pay attention to it.

So if a PEG of about 1.0 is where the shares will trade, what are the implications of a 15,000-employee-per-year growth in head count?

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At the time of publication, Trent had no positions in the stocks mentioned, although positions may change at any time.

William A. Trent, CFA, is a freelance equity analyst based in the New York metro area. He has been an equity analyst since 1996 and is co-author of Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Trent appreciates your feedback; click here to send him an email.