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Summary

  • We pitch two companies from the home improvement stores sector, Home Depot and Lowe's, against one another in the latest instalment of our Head-To-Head series.
  • The article focuses on the relative strengths and weaknesses of Home Depot and Lowe's, based on business performance and sustainability/dividends/forecasts.
  • It ends with discussion of the current valuations of the two companies, and details whether Home Depot represents good relative value at current price levels.

Home Depot Background

Home Depot (NYSE:HD) was founded in 1978, and is based in Atlanta, Georgia. Its stores sell various building materials, home improvement products, and lawn and garden products, as well as provide installation, home maintenance, and professional service programs to do-it-yourself, do-it-for-me, and professional customers. The company offers installation programs that include flooring, cabinets, countertops, water heaters, and sheds, as well as acts as a contractor to provide installation services to its do-it-for-me customers through third-party installers. It primarily serves professional remodelers, general contractors, repairmen, small business owners, and tradesmen.

Team Money Research Rating

Our investment philosophy is to focus on company fundamentals and identify stocks that are displaying strong business performance, that operate sustainably and that pay a decent, well-covered dividend.

We score each company relative to the other on the following criteria within each of our two main buckets:

Business Performance

  1. Return on equity
  2. Return on assets
  3. Operating margins
  4. Quarterly revenue growth
  5. Quarterly earnings growth

Sustainability/Dividends/Forecasts

  1. Debt-to-equity ratio
  2. Interest cover
  3. Dividend payout ratio
  4. Forward yield
  5. Annual EPS growth forecast

Once we have scores for the two buckets, we can then assess whether a company represents good value based on the current prices of the two stocks. We use the following criteria to assess valuations on a relative basis.

Valuation

  1. Forward price-to-earnings ratio
  2. Price-to-book value ratio
  3. Enterprise value-to-EBITDA
  4. Price-to-3 year average free cash flow ratio
  5. 5 year price-to-earnings growth ratio

So, for example, a company that scores well compared to its rival on the first two buckets (business performance and sustainability/dividends/forecasts) and that is undervalued relative to its peer (based on the third bucket: valuation) could outperform its competitor going forward.

The table below highlights the data that we will use to score Home Depot and Lowe's (NYSE:LOW) for the first two buckets.

Stock

Home Depot

Lowe's

Business Performance

Return on equity

38.81%

19.16%

Return on assets

13.46%

7.82%

Operating margins

11.78%

8.03%

Quarterly rev. growth

2.90%

2.40%

Quarterly EPS growth

12.50%

15.60%

Sustainability/Dividends/Forecast

Debt-to-equity ratio

121.37%

88.20%

Interest cover

12.45

8.60

Dividend payout ratio

42.00%

32.00%

Forward dividend yield

2.30%

2.00%

Annual EPS growth forecast

16.10%

20.30%

We then score each company relative to its peer, based on the above data, with points being awarded as follows:

1st place: 10 points

2nd place: 0 points

Below are the scores for Home Depot and Lowe's:

Stock

Home Depot

Lowe's

Business Performance

Return on equity

10

0

Return on assets

10

0

Operating margins

10

0

Quarterly rev. growth

10

0

Quarterly EPS growth

0

10

Sustainability/Dividends/Forecast

Debt-to-equity ratio

0

10

Interest cover

10

0

Dividend payout ratio

0

10

Dividend yield

10

0

Annual EPS growth forecast

0

10

Total Score

60

40

As you can see, Home Depot beats Lowe's in our first two buckets, with a score of 60 versus 40 points. However, we feel that the overall score does not reflect the high quality of Home Depot, since the areas in which it lost out to Lowe's, it only did so by fairly narrow margins and still posted strong figures. For instance, in terms of the debt-to-equity ratio, while it is higher for Home Depot than for Lowe's (121.37% versus 88.20%), we feel comfortable with Home Depot's current level of leverage, a point that is backed up by ample interest cover of 12.45.

In addition, although Home Depot's quarterly earnings growth numbers were slightly below those of Lowe's last quarter (12.50% versus 15.60%), we still view quarterly bottom line growth of 12.50% as being highly impressive. Furthermore, Home Depot's payout ratio of 42% remains fairly low and highlights the potential for the company to increase dividends per share at a brisk pace going forward, which could help to push the yield higher.

Home Depot, of course, scored well in terms of its profitability, where its stronger operating margins and higher return on equity and assets proved too strong for Lowe's. Allied to this is strong growth forecasts for next year of 16.10% which, although less than those of Lowe's, still represent very strong growth potential.

As such, we were impressed with the performance of Home Depot and feel it fully deserved to come out of the first two buckets with a better score than Lowe's.

Valuation

So, we feel that Home Depot has performed well in the first two buckets and, as such, should trade at a premium to its peer Lowe's. Let's see if it does.

Stock

Home Depot

Lowe's

Valuation

Forward price-to-earnings ratio

15.53

15.10

Price-to-book ratio

8.95

4.16

EV/EBITDA

10.87

9.57

PEG

1.11

1.10

Price-to-free cash flow ratio

18.85

17.25

We're surprised at how narrow the valuation premium is for Home Depot versus Lowe's - we expected it to be considerably wider after the results from the first two buckets. Indeed, although all five valuation criteria show that Home Depot trades at a premium to Lowe's right now, a P/E premium of just 2.85% seems too low given Home Depot's strong showing in the first two buckets. Furthermore, the two companies' PEG ratios are almost identical (1.11 for Home Depot versus 1.10 for Lowe's), while the price-to-free cash flow ratio is again at a premium of 9.28%, which seems rather tight to us. As such, we feel that Home Depot deserves to trade at a greater premium to Lowe's, which means that, going forward, we think it will outperform its peer.

Conclusion

Home Depot is a high-quality company that we believe offers good value at current levels. It scored well on the Team Money Research rating system, beating its home improvement stores rival by 60 points to 40. It also appears to be relatively undervalued at current levels, since although it trades at a premium on all five of our valuation criteria, we believe the premium should be higher. As such, we feel that Home Depot could outperform its sector peer Lowe's going forward.

Feedback Request: Which stocks do you want to see go head-to-head against Home Depot in future Team Money Research articles? Please comment below!

Source: Why Home Depot Could Outperform This Sector Peer