What Is Correct Way to Value Homebuilders?

The bargain bin approach can be very rewarding in our industry. But it is something that is very hard and needs time and practice. Right now many voices are saying that the builders are a good pick for this kind of strategy. They say that the P/E is so low that it makes sense to own these stocks. At 4 to 6 times the P/E I agree it is very cheap and normally you would be sure to make some money.

But you need to ask why there is this low valuation and you need to know if the valuation is correct. I have taken a look at some of the major builders' financial statements with one thing in mind: what is the correct valuation when you take out the bubble premium. So I took a look at the earnings for 2001 and 2002 assuming that this will be the correct valuation for the future because the bust of the bubble will probably bring down the number of houses they will build and the price of the house.

Brookfield Homes (BHS) Earning for 2005 : 7.04$ Before the bubble 2001: 1.23$ 2002: 1.35$ average : 1.29 valuation at current price with pre-bubble earning: P/E of 20 to 21

Toll Brothers (TOL) Earning for 2005 : 4.78$ Before the bubble 2001: 1.38$ 2002: 1.46$ average : 1.42 valuation at current price with pre-bubble earning: P/E of 19 to 20

Pulte Homes (PHM) Earning for 2005 : 5.47$ Before the bubble 2001: 1.52$ 2002: 1.79$ average : 1.66$ valuation at current price with pre-bubble earning: P/E of 19 to 20

Centex (CTX) Earning for 2005 : 7.64$ Before the bubble 2001: 2.18$ 2002: 3.58$ average : 2.88$ valuation at current price with pre-bubble earning: P/E of 18 to 19

Meritage Homes (MTH) Earning for 2005 : 8.88$ Before the bubble 2001: 2.15$ 2002: 2.66$ average : 2.41$ valuation at current price with pre-bubble earning: P/E of 18 to 19

Ryland Group (RYL) Earning for 2005 : 9.03$ Before the bubble 2001: 2.32$ 2002: 3.32$ average : 2.82$ valuation at current price with pre-bubble earning: P/E of 16 to 17

KB Home (KBH) Earning for 2005 : 9.53$ Before the bubble 2001: 2.75$ 2002: 3.58$ average : 3.17$ valuation at current price with pre-bubble earning: P/E of 14 to 15

Lennar (LEN) Earning for 2005 : 8.23$ Before the bubble 2001: 2.73$ 2002: 3.51$ average : 3.12$ valuation at current price with pre-bubble earning: P/E of 14 to 15

Beazer Homes (BZH) Earning for 2005 : 5.87$ Before the bubble 2001: 2.73$ 2002: 3.58$ average : 3.14 valuation at current price with pre-bubble earning: P/E of 12 to 13

D R Horton (DHI) Earning for 2005 : 4.71$ Before the bubble 2001: 2.23$ 2002: 2.87$ average : 2.55$ valuation at current price with pre-bubble earning: P/E of 9 to 10

M D C HOLDINGS (MDC) Earning for 2005: 10.99$ Before the bubble 2001: 5.20$ 2002: 5.48$ average: 5.34$ valuation at current price with pre-bubble earning: P/E of 9 to 10

Now you have a much clearer picture of the correct valuation for the builders. You still have to add a risk premium. Normally when an industry is going down a lot of dirt will be uncovered; I won’t be surprised if some of the builders take some charge on the future for houses not sold, higher cost of financing because of houses not sold and so on. After that, if you still think that some of the builders are a good buy you need to take a look at the 10k or 10q filings to see where they are building and to monitor the real estate market in this sector to see if the market will be more or less affected by the bust of the bubble.

Comment on this article

Comments

[stefaith:]

To value hombuilders on the basis of 2001 profitability or 2001 returns on investment makes sense. However, most builders are much bigger now than they were in 2001 so to simply assume that eps will return to 2001 levels is naive.

They have more capital to deploy, have larger market shares, they are not the same companies that they were in 2001

2006 Sep 22 02:37 AM

[Mathieu Lag...:]

I Agree that it is a simple analysis, my point is to give a warning that builder are not a value play right now. But keep in mind they are bigger because it is a bubble market and they won't build as many houses as the did in the past couple of year. The capital the have now can evaporate real fast if they have support unsold inventory and sold at loss. I had lot of commentary about this article and I will be honest with you that the correct way I should have done it is 2001-2002 eps plus a premium like 15-20%. Still It is not a value play for most of them.

2006 Sep 22 11:14 AM

[Fritz Claridge:]

Very interesting and informative comparison. I "lived" through the last bubble and California earthquake.
There was much digestion over a period of 1-2 years; nevertheless, the market came back with an additional 3 to 5X premium to pre bubble 'values'.

I feel comfortable with an experienced management and believe one has to be early to the party. It often gets uncomfortable, yet were one to believe that housing will 'come back' (as do I), today's stock prices appear to be a good entry point. Measurements such as PE, book value, Value Play, and Market are almost meaningless other than to compare among builders. Your selection of anticipated P/E is as good as any well thought out devise.

My key is to spread the risk by investing in several builders; do not use margin; and look for a long term (1 year) opportunity. One may check the builders ETF which appears excellent to me and spreads the risk (check out their holdings).

I am not a pumper. I have sold LEAPS of 08 and 09 on most of the builders including JOE and WCI (when they were at lower prices and with my diaper tightly wrapped aroung my waist).

Good hunting, Fred H. Claridge

2006 Sep 22 11:50 AM

[walter davi...:]

I dont know what is going on with the homebuilders, if this was another sector wallstreet would have sent them into the basement by now. The long term H&S formation projects down to 31 on Lennar Homes.
What gives??

2006 Sep 22 12:24 PM