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For investors looking to invest in the U.S. housing recovery, Lowe's (NYSE:LOW) is a retail building supply store that currently has strong fundamentals, pays a 1.5% yield and is in a growing sector; but is it overvalued?

In the section below, I will analyze aspects of Lowe's past performance. From this evaluation, we will be able to see how Lowe's 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 = $1.783 billion
  • Net income 2011 = $2.010 billion
  • Net income 2012 = $1.839 billion
  • Net income 2013 = $1.959 billion
  • Net income 2014 TTM = $2.269 billion

Over the past five years, Lowe's net profits have increased from $1.783 billion in 2010, to $2.269 billion in 2014 TTM, which represents a 27.26% increase.

  • Operating income 2010 = $3.112 billion
  • Operating income 2011 = $3.560 billion
  • Operating income 2012 = $3.277 billion
  • Operating income 2013 = $3.560 billion
  • Operating income 2014 TTM = $4.087 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, Lowe's operating income has increased from $3.112 billion to $4.087 billion in 2014 TTM. This represents an increase of 31.33%.

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 = $1.783 billion
    • Net income 2011 = $2.010 billion
    • Net income 2012 = $1.839 billion
    • Net income 2013 = $1.959 billion
    • Net income 2014 TTM = $2.269 billion
  • Total asset growth

    • Total assets 2010 = $33.005 billion.
    • Total assets 2011 = $33.699 billion
    • Total assets 2012 = $33.559 billion.
    • Total assets 2013 = $32.666 billion.
    • Total assets 2014 TTM = $34.077 billion.
  • ROA - Return on assets

    • Return on assets 2010 = 5.40%.
    • Return on assets 2011 = 5.96%
    • Return on assets 2012 = 5.48%
    • Return on assets 2013 = 6.00%.
    • Return on assets 2014 TTM = 6.67%.

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

LOW Return on Assets (TTM) data by YCharts

Over the past five years, Lowe's ROA has increased from 5.40% in 2010 to 6.67% in 2014 TTM. This indicates that the company is making more on its assets than it did in 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 = $33.005 billion.
    • Total assets 2011 = $33.699 billion
    • Total assets 2012 = $33.559 billion.
    • Total assets 2013 = $32.666 billion.
    • Total assets 2014 TTM = $34.077 billion.
    • Equals an increase of $1.072 billion
  • Total liabilities

    • Total liabilities 2010 = $13.936 billion
    • Total liabilities 2011 = $15.587 billion
    • Total liabilities 2012 = $17.026 billion
    • Total liabilities 2013 = $18.809 billion
    • Total liabilities 2014 TTM = $21.426 billion
    • Equals an increase of $7.490 billion

Over the past five years, Lowe's total assets have increased by $1.072 billion, while the total liabilities have increased by $7.490 billion. This indicates that the Lowe'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 = $9.732 billion
    • Current assets 2011 = $9.967 billion
    • Current assets 2012 = $10.072 billion
    • Current assets 2013 = $9.784 billion
    • Current assets 2014 TTM = $11.365 billion
  • Current liabilities

    • Current liabilities 2010 = $7.355 billion
    • Current liabilities 2011 = $7.119 billion
    • Current liabilities 2012 = $7.891 billion
    • Current liabilities 2013 = $7.708 billion
    • Current liabilities 2014 TTM = $9.403 billion
  • Current ratio 2010 = 1.32
  • Current ratio 2011 = 1.40
  • Current ratio 2012 = 1.28
  • Current ratio 2013 = 1.30
  • Current ratio 2014 TTM = 1.21

Over the past five years, Lowe's current ratio fluctuated between 1.4 an 1.21. As the current ratio is currently above 1, this indicates that Lowe's would be able to pay off its obligations if they came due at this point.

Common Shares Outstanding

  • 2010 shares outstanding = 1.46 billion.
  • 2011 shares outstanding = 1.35 billion
  • 2012 shares outstanding = 1.24 billion.
  • 2013 shares outstanding = 1.11 billion
  • 2014 TTM shares outstanding = 1.05 billion

LOW Shares Outstanding Chart

LOW Shares Outstanding data by YCharts

Over the past five years, the number of company shares have decreased. The company shares have decreased from 1.46 billion to 1.05 billion. This represents a reduction of 28.08%

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 = $16.463 billion / $47.220 billion = 34.86%.
  • Gross margin 2011 = $17.152 billion / $48.815 billion = 35.13%
  • Gross margin 2012 = $17.350 billion / $50.208 billion = 34.56%.
  • Gross margin 2013 = $17.327 billion / $50.521 billion = 34.30%.
  • Gross margin 2014 TTM = $18.219 billion / $52.803 billion = 34.50%.

Over the past five years, Lowe's gross margin has been remained relatively even. The ratio has bounced between 35.13% and 34.30% over the past five years.

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 = $47.220 billion
    • Revenue 2011 = $48.815 billion
    • Revenue 2012 = $50.208 billion
    • Revenue 2013 = $50.521 billion
    • Revenue 2014 TTM = $52.803 billion
    • Equals an increase of 11.82%
  • Total Asset growth

    • Total assets 2010 = $33.005 billion.
    • Total assets 2011 = $33.699 billion
    • Total assets 2012 = $33.559 billion.
    • Total assets 2013 = $32.666 billion.
    • Total assets 2014 TTM = $34.077 billion.
    • Equals an increase of 3.04%.

Over the five years the revenue growth has increased by 11.82% while the company assets have increased by 3.04%. 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 Lowe's has done well over the past five years. The net income over the past five years, has increased by 27.26%, the revenue has increased by 11.82%, while the company's assets have increased by 3.04%. These three metrics indicate that the profitability of the company has increased over the past five years.

As the U.S. housing market has begun to show signs of recovery, Lowe's stock price has also responded. Since early 2012 when the stock broke out, the valuation has done very well. So the next question is at this level is the stock overvalued?

LOW Chart

LOW data by YCharts

Valuations

In the section below, I will use three 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 - $50.558 billion + 10.141 billion - 1.101 billion = $59.598 billion
  • EV = 59.598 billion
  • EBITDA = 5.666 billion
  • EV/EBITDA = 10.52

As the Retail Building Supply sector often trades in the 12.95 trading range, an EV/EBITDA ratio of 10.52 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 Lowe's 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.

(click to enlarge)

Even though there are variations in calculating this formula, this model is based off of a terminal value of $56.660B and a WACC of 5.5%. The terminal value $56.660B is based off of the company trading at 10x EBITDA which is well below the EV/EBITDA value of 12.95 for the industry. At this point in the market, using the valuations above, I have concluded Lowe's current value to be $65.76 per share.

Forward P/E

In another method, I will use Lowe's forward P/E ratios with estimated earnings to find the value. Currently, Home Depot has a forward P/E of 18.15 and FY 2016 earnings projected at $3.17. These two metrics lead to a target price of $57.54.

As of January 23rd, Lowe's stock was trading at $48.15. Using the Discount Cash Flow Formula, this indicates the stock is trading at a 36.69% discount to today's price.

Financial Highlights moving forward

According to the Q3 2013 Slides and Reconciliation of Non-GAAP Measures Lowe's has many positive signals moving forward.

  • Total sales are expected to increase approximately 6%
  • Comparable sales are expected to increase approximately 5%
  • The company expects to open 9 stores in fiscal year 2013
  • Earnings before interest and taxes as a percentage of sales (operating margin) are expected to increase approximately 75 basis points
  • Diluted earnings per share of approximately $2.15 are expected for the fiscal year ending January 31, 2014
  • Cash flow from operations are expected to be approximately $3.8B
  • Capital expenditures are expected to be approximately $900M
  • The company expects to repurchase $3.7B of stock

Strategy

Even though the stock has had an impressive price run over the past couple of 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 couple of years, Lowe's stock has been on a very impressive price run. Based on a 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 Lowe's is currently undervalued and have calculated it is trading at a 36.69% discount to today's price.

Source: Lowe's: A Good Time To Buy?