Don't Fall Into Cognizant's Value Trap

For simplicity's sake, I am assuming that the employee growth will predict the following year's revenue growth and that margins will be constant. Increased utilization could make those estimates conservative, while a rising rupee and ongoing wage inflation could make them appear aggressive.

For this illustration, I'm implicitly assuming those factors will cancel each other out. If you disagree, it is a fairly simple matter to adjust my assumptions to fit your forecast.

Here's how things would trend using those assumptions for the next five years:

Year	Employees	Growth	EPS	PE	Price
2007	55,000	37.50%	$1.14	37.5	$42.75
2008	70,000	27.30%	$1.45	27.3	$39.61
2009	85,000	21.40%	$1.76	21.4	$37.70
2010	100,000	17.60%	$2.07	17.6	$36.48
2011	115,000	15.00%	$2.38	15	$35.75
2012	130,000	13.00%	$2.69	13	$35.03

The increase in earnings is offset by an equal or greater reduction in the growth rate. Today's buyer at $33 on the basis of a low P/E/G ratio should be prepared to sell in five years for a whole $35.

Another Perspective

As I said, I don't put much faith in the P/E/G ratio. Therefore, I don't want to draw all my conclusions from it, despite its past usefulness in explaining the stock price. For another perspective, I turn to my favorite tool, free-cash-flow yield.

In the last 12 months, Cognizant generated about $138 million in free cash flow (cash from operations less capital expenditures). With a $9.5 billion market cap after today's shellacking, the yield is still less than 1.5% -- far lower than I could earn on a risk-free Treasury bond.

On the other hand, Cognizant's cash flow could grow, while the Treasury interest payment will not. In the past, cash flow has risen in line with earnings. However, in the last 12 months, it has not grown even though EPS have. Still, I will assume that the free cash flow will match the earnings growth over the next five years to reach $326 million in 2012.

By then, the growth will have sufficiently normalized that I would expect at least a Treasury-like yield. At 20 times the free cash flow, I would only be willing to assign a $6.5 billion valuation in five years. That is nearly a third less than the current valuation.

Either way I cut it, Cognizant is looking to me like a high-growth value trap.

---

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.