The methodology

Krishnan Thiagarajan

IN AN increasingly volatile technological environment, applying the discounted cash flow (DCF) technique to the software services sector may seem unrealistic.

In the software industry, though the cashflows of almost all companies are positive, the accurate estimation of future cash flows is difficult.

As the industry is dynamic, instead of estimating the growth rate of `cash earnings', an attempt was made to use the latest `cash earnings' to arrive at the growth rate that justifies the current market value (or market capitalisation) of software companies considered in the sample.

The methodology developed in the Business Line Investment World Edition of March 26, was carried forward by updating the cash earnings for the accounting year 1999-2000 and adding more software companies to the earlier list to make the study comprehensive. The earlier study was based on cash earnings for 1998-99.

For the 23 software companies in the sample, the latest market capitalisation (current market price as of September 11 was multiplied by the number of equity shares) and then the cash earnings were computed for 1999-2000. Using the Capital Asset Pricing Model (CAPM), the discount rate was arrived at to estimate the required growth rate of cash earnings to justify the current market capitalisation.

The discount rate was arrived at by estimating/computing three key variables - the risk-free rate of return, the market risk premium and the beta for the software industry. The risk-free rate was assumed as the 10-year gilt benchmark of around 11 per cent. The market risk premium was arrived at by subtracting the risk-free rate from the average market return (of any broadbased market index).

The average market return based on the broadbased BSE-100 Index worked out to 20 per cent over the past 15 years. The beta estimate for the software industry (using the BL-250 Index and BL Technology Index) was 1.10. Applying these three variables to the CAPM model, the discount rate arrived at was 23 per cent. Calculating conservatively, a constant discount rate of 22 per cent was used

As the industry is dynamic, and is likely to mature over the next 20-25 year, a four-stage model of growth was assumed for software companies. For instance, if the growth rate for the next five years is expected to be 70 per cent for a company, it is assumed to be 35 per cent from the sixth to the tenth year, and 17.50 per cent from the eleventh to the twentieth.

In the fourth stages, after twenty years, the companies are assumed to grow at a constant rate of 10 per cent. In this analysis, obviously, the first five years in the industry's life-cycle hold the key to `sustainable' IT valuations.