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For investors looking to invest in the U.S. housing recovery, The Home Depot (NYSE:HD) is a retail building supply store that currently has strong fundamentals, pays a 1.8% yield and is in a growing sector; but is it overvalued?

In the section below, I will analyze aspects of Home Depot's past performance. From this evaluation, we will be able to see how Home Depot has fared over the past five years regarding their profitability, debt and capital, and operating efficiency. Based on this information, we will look for strengths and weaknesses in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future.

Profitability

Profitability is a class of financial metrics used to assess a business's ability to generate earnings, compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2010 = $2.661 billion
  • Net income 2011 = $3.338 billion
  • Net income 2012 = $3.883 billion
  • Net income 2013 = $4.535 billion
  • Net income 2014 TTM = $5.393 billion

Over the past five years, Home Depot's net profits have increased from $2.661 billion in 2010, to $5.393 billion in 2014 TTM, which represents a 102.67% increase.

  • Operating income 2010 = $4.803 billion
  • Operating income 2011 = $5.839 billion
  • Operating income 2012 = $6.661 billion
  • Operating income 2013 = $7.766 billion
  • Operating income 2014 TTM = $9.155 billion

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past five years, Home Depot's operating income has increased from $4.803 billion to $9.155 billion in 2014 TTM. This represents an increase of 90.61%.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

  • Net income growth

    • Net income 2010 = $2.661 billion
    • Net income 2011 = $3.338 billion
    • Net income 2012 = $3.883 billion
    • Net income 2013 = $4.535 billion
    • Net income 2014 TTM = $5.393 billion
  • Total asset growth

    • Total assets 2010 = $40.877 billion.
    • Total assets 2011 = $40.125 billion
    • Total assets 2012 = $40.518 billion.
    • Total assets 2013 = $41.084 billion.
    • Total assets 2014 TTM = $43.814 billion.
  • ROA - Return on assets

    • Return on assets 2010 = 6.51%.
    • Return on assets 2011 = 8.32%
    • Return on assets 2012 = 9.58%
    • Return on assets 2013 = 11.03%.
    • Return on assets 2014 TTM = 12.31%.

HD Return on Assets (NYSE:<a href='http://seekingalpha.com/symbol/ttm' title='Tata Motors Limited'>TTM</a>) Chart

HD Return on Assets ((TTM)) data by YCharts

Over the past five years, Home Depot's ROA has increased from 6.51% in 2010 to 12.31% in 2014 TTM. This indicates that the company is making more on its assets than it did a few years ago.

Debt And Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2010 = $40.877 billion.
    • Total assets 2011 = $40.125 billion
    • Total assets 2012 = $40.518 billion.
    • Total assets 2013 = $41.084 billion.
    • Total assets 2014 TTM = $43.814 billion.
    • Equals an increase of $2.937 billion
  • Total liabilities

    • Total liabilities 2010 = $21.484 billion
    • Total liabilities 2011 = $21.236 billion
    • Total liabilities 2012 = $22.620 billion
    • Total liabilities 2013 = $23.307 billion
    • Total liabilities 2014 TTM = $29.600 billion
    • Equals an increase of $8.116 billion

Over the past five years, Home Depot's total assets have increased by $2.937 billion, while the total liabilities have increased by $8.116 billion. This indicates that HD's assets have not increased as much as the liabilities.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current assets

    • Current assets 2010 = $13.900 billion
    • Current assets 2011 = $13.479 billion
    • Current assets 2012 = $14.520 billion
    • Current assets 2013 = $15.372 billion
    • Current assets 2014 TTM = $18.598 billion
  • Current liabilities

    • Current liabilities 2010 = $10.363 billion
    • Current liabilities 2011 = $10.122 billion
    • Current liabilities 2012 = $9.376 billion
    • Current liabilities 2013 = $11.462 billion
    • Current liabilities 2014 TTM = $12.529 billion
  • Current ratio 2010 = 1.34
  • Current ratio 2011 = 1.33
  • Current ratio 2012 = 1.59
  • Current ratio 2013 = 1.34
  • Current ratio 2014 TTM = 1.48

Over the past five years, Home Depot's current ratio hovered around 1.34. As the current ratio is currently above 1, this indicates that Home Depot would be able to pay off its obligations if they came due at this point.

Common Shares Outstanding

  • 2010 shares outstanding = 1.70 billion.
  • 2011 shares outstanding = 1.62 billion
  • 2012 shares outstanding = 1.54 billion.
  • 2013 shares outstanding = 1.48 billion
  • 2014 TTM shares outstanding = 1.41 billion

HD Shares Outstanding Chart

HD Shares Outstanding data by YCharts

Over the past five years, the number of company shares have decreased. The company shares have decreased from 1.70 billion to 1.41 billion. This represents a reduction of 21.43%

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The Gross Profit Margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross margin 2010 = $22.412 billion / $66.176 billion = 33.87%.
  • Gross margin 2011 = $23.304 billion / $67.997 billion = 34.27%
  • Gross margin 2012 = $24.262 billion / $70.395 billion = 34.47%.
  • Gross margin 2013 = $25.842 billion / $74.754 billion = 34.57%.
  • Gross margin 2014 TTM = $27.564 billion / $79.362 billion = 34.73%.

Over the past five years, HD's gross margin has been increasing. The ratio has increased from 33.87% in 2010 to 34.73% in 2014 TTM.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $66.176 billion
    • Revenue 2011 = $67.997 billion
    • Revenue 2012 = $70.395 billion
    • Revenue 2013 = $74.754 billion
    • Revenue 2014 TTM = $79.362 billion
    • Equals an increase of 19.93%
  • Total Asset growth

    • Total assets 2010 = $40.877 billion.
    • Total assets 2011 = $40.125 billion
    • Total assets 2012 = $40.518 billion.
    • Total assets 2013 = $41.084 billion.
    • Total assets 2014 TTM = $43.814 billion
    • Equals an increase of 5.40%.

Over the five years, the revenue growth has increased by 19.93% while the company assets have increased by 5.40%. This is an indication that the company from a percentage point of view has been more efficient at generating revenue with its assets.

Based on the information above we can see that Home Depot has had five very strong years. The net income over the past five years, has increased by 102.67%, the revenue has increased by 19.93%, while the company's assets have increased by 5.40%. These three metrics indicate that the profitability of the company has increased significantly over the past five years. A couple of other positives are: the ROA has increased significantly while the company's shares have decreased thus creating shareholder value.

Partially due to the factors indicated above the company shares have increased in value over the past five years. According to the chart below the company's stock price has increased from ~$30.00 in 2010 to the current price of $80.20. So the next question is: Is the stock overvalued?

HD Chart

HD data by YCharts

Valuations

In the section below, I will use a couple of different methods to find a valuation of the stock price. In this section, I will use the EV/ EBITDA to assess if the stock is over or undervalued compared to the industry average, the Discounted Cash Flow valuation model and forward P/E ratios to estimate the current value of each share.

EV/EBITDA = Enterprise Value / Earnings before interest, Taxes, Depreciation and Amortization

In the next section, I will use the EBITDA to calculate the EV/EBITDA. The adjusted EBITDA takes into account foreign exchange and share-based payment expenses. The EV/EBITDA ratio is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm. Companies in the Retail Building Supply typically have an EV/EBITDA ratio that trades in the 12x to 13x trading range.

Enterprise Value or EV = Market Capitalization + Total Debt - Cash and Cash Equivalents.

  • EV - $115.634 billion + 10.796 billion - 2.494 billion = $123.936 billion
  • EV = 123.936 billion
  • EBITDA = 10.899 billion
  • EV/EBITDA = 11.37

As the Retail Building Supply sector often trades in the 12.95 trading range, an EV/EBITDA ratio of 11.37 indicates at current levels the stock is trading under fair value compared to other companies in its sector.

Discounted Cash Flow

I believe using the Discounted Cash Flow valuation model for The Home Depot to be fair because DCF analysis can help one see where the company's value is coming from and one can generate an opinion based on that.

Even though there are variations in calculating this formula, this model is based off of a terminal value of $141.142B and a WACC of 6.01%. The terminal value $141.142B is based off of the company trading at 12.95x EBITDA which is the EV/EBITDA value for the industry. At this point in the market, using the valuations above, I have concluded Home Depot's current value to be $95.63 per share.

Forward P/E

In another method, I will use Home Depot's forward P/E ratios with estimated earnings to find the value. Currently, Home Depot has a forward P/E of 18.09 and FY 2016 earnings projected at $5.15. These two metrics lead to a target price of $93.16.

As of January 22nd, Home Depot's stock was trading at $80.20. Using the Discounted Cash Flow Formula, this indicates the stock is trading at a 19.23% discount to today's price.

Outlook for 2014

In 2014, Home Depot is looking to continue to capitalize on the housing recovery. The company is expecting continued growth and with that growth increase shareholder value. Listed below is the company's plan for 2014.

  • Sales growth of ~5%
  • 8 new stores
  • Operating margin expansion of approximately 70 basis points
  • Share repurchases of approximately $5.0 billion
  • Diluted earnings-per-share growth after anticipated share repurchases of approximately 17%
  • Capital spending of approximately $1.5 billion

Strategy

Even though the stock has had an impressive price run over the past five years, I still believe the stock price has more to go. I believe if you added a position here and waited for the "bad news" or the overall market to bring the price down, this would be an excellent time to invest in a company with excellent fundamentals, great business plan and a market that will need their products.

Conclusion

Over the past five years, Home Depot's stock has been on a very impressive price run. Based on an improving market and customer satisfaction creating very strong fundamentals, I believe any pullback in price is a buying opportunity. At current levels using the valuation metrics above, I have concluded that The Home Depot is currently undervalued and have calculated it is trading at a 19.23% discount to today's price.

Source: Home Depot: Is It Overvalued?