What is stock analysis? Well, there are some that think it has everything to do with the dividend. There are others that only look at charts. There are others that think that analyst estimate misses (notice how this is equivalent to companies' earnings beats) are a way to gauge the trajectory of a stock. And yet there are other groups that are lost in medieval times. We as investors need to move beyond these individual frameworks and start taking a holistic view. Let's take a look at what we mean as it relates to our analysis with Home Depot (HD).
At our independent investment research firm, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). More interest in the stock = more buying = higher stock price.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Home Depot posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. We compare Home Depot to peers Bed Bath & Beyond (BBBY), Best Buy (BBY), Lowe's (LOW), and Office Depot (ODP).
- Home Depot's scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 10.7% during the past three years.
- Home Depot is the world's largest home improvement specialty retailer. Its stores sell a wide assortment of building materials, home improvement and lawn and garden products and provide a number of services.
- Home Depot has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 8.2% in coming years. Total debt-to-EBITDA was 1.1 last year, while debt-to-book capitalization stood at 37.8%.
- The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
- Home Depot's financial performance depends on the stability of the housing, residential construction and home improvement markets. These markets can and do experience wild swings, however.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Home Depot's 3-year historical return on invested capital (without goodwill) is 10.7%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreationTM rating of GOOD. In the chart to the right, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
We think Home Depot is worth $65 per share. Our discounted cash flow model indicates that Home Depot's shares are worth between $49-$81 each. Ever wonder why we use such a large margin of safety? Click here. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRiskTM rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $65 per share represents a price-to- earnings (P/E) ratio of about 21.7 times last year's earnings and an implied EV/EBITDA multiple of about 11.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 4.1%. Our model reflects a 5-year projected average operating margin of 13.3%, which is above Home Depot's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For Home Depot, we use a 10.2% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $65 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRiskTM rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Home Depot. We think the firm is attractive below $49 per share (the green line), but quite expensive above $81 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Home Depot's fair value at this point in time to be about $65 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of Home Depot's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $84 per share in Year 3 represents our existing fair value per share of $65 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.