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Summary

  • Home Depot reported an amazing quarter earlier this week, sending shares to new highs.
  • HD is also a dividend growth story as it returns enormous amounts of capital to shareholders.
  • Shares have a current fair value of ~$99, making HD a strong buy.

Shares in retailer Home Depot (NYSE:HD) surged yesterday on the company's latest earnings report as the company blew away expectations. After largely trading sideways for the past year we saw HD break out to more than $88, marking new all-time highs for the company. After this surge are shares too expensive? In this article we'll explore that possibility and see of HD is still a value stock based upon fundamentals.

(click to enlarge)

To do this I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at 6% growth annually, and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 6.4%.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$3.76

$4.41

$5.12

$5.95

$6.92

$8.04

x(1+Forecasted earnings growth)

17.30%

16.10%

16.23%

16.23%

16.23%

16.23%

=Forecasted earnings per share

$4.41

$5.12

$5.95

$6.92

$8.04

$9.35

Equity Book Value Forecasts

Equity book value at beginning of year

$8.88

$11.41

$14.54

$18.38

$23.06

$28.72

Earnings per share

$4.41

$5.12

$5.95

$6.92

$8.04

$9.35

-Dividends per share

$1.88

$1.99

$2.11

$2.24

$2.37

$2.52

=Equity book value at EOY

$8.88

$11.41

$14.54

$18.38

$23.06

$28.72

$35.55

Abnormal earnings

Equity book value at begin of year

$8.88

$11.41

$14.54

$18.38

$23.06

$28.72

x Equity cost of capital

8.75%

8.75%

8.75%

8.75%

8.75%

8.75%

8.75%

=Normal earnings

$0.78

$1.00

$1.27

$1.61

$2.02

$2.51

Forecasted EPS

$4.41

$5.12

$5.95

$6.92

$8.04

$9.35

-Normal earnings

$0.78

$1.00

$1.27

$1.61

$2.02

$2.51

=Abnormal earnings

$3.63

$4.12

$4.68

$5.31

$6.02

$6.83

Valuation

Future abnormal earnings

$3.63

$4.12

$4.68

$5.31

$6.02

$6.83

x discount factor(0.0875)

0.920

0.846

0.778

0.715

0.657

0.605

=Abnormal earnings disc to present

$3.34

$3.49

$3.64

$3.80

$3.96

$4.13

Abnormal earnings in year +6

$6.83

Assumed long-term growth rate

3.00%

Value of terminal year

$118.82

Estimated share price

Sum of discounted AE over horizon

$18.22

+PV of terminal year AE

$71.83

=PV of all AE

$90.05

+Current equity book value

$8.88

=Estimated current share price

$98.93

As you can see the model calculates a fair value of about $99, or $11 higher than we closed yesterday. That is a large discrepancy so we'll investigate the difference to see if HD really is worth $99 today.

To begin, the model calculates a fair value and not a price target. Price targets are forward looking; the investor estimates earnings for some future period and then multiplies those earnings by an earnings multiple in order to project a price into a future period. The fair value calculates the value of shares today based upon the inputs I described above. In other words, the present value of HD's discounted earnings, adjusted for dividends, is $99 based upon the inputs I described above. This would indicate shares are a strong buy at $88.

So what is there to like about HD? The short answer is "a lot" but let's explore a little deeper. The quarter reported this week from HD can be described as nothing less than outstanding. The company beat on every major metric there is and showed that the earnings momentum it has enjoyed in recent years is continuing in a big way. HD's US stores showed blistering comp sales growth of 6.4%, which is ridiculous for a mature retailer the size of HD. Transactions and average ticket size both rose, driving the comp sales growth. This is terrific as we know that HD not only attracted more customers into stores but those customers spent more before leaving as well. This is the best case scenario for comp sales and HD knocked it out of the park. Finally, sales per square foot moved up a robust 5.5% as well, further cementing the outstanding performance of the company during the quarter.

In other words, HD had absolutely nothing to complain about during the quarter as everything that could go right, did. On top of that, the company also boosted its buyback program to a total of $7 billion for 2014, above its previous estimate of $5 billion. I love buybacks as a way to return capital to shareholders and HD's buyback program is huge. $7 billion is good for nearly 6% of the company's market cap, a princely sum for one year's worth of buyback activity. HD management sees the value in shares here and they are spending in order to retire as many shares as possible.

So we've established that HD's fundamentals are amazing right now but there is yet another piece of this stock that I haven't mentioned yet; the dividend. Not only is HD powering higher on tremendous fundamentals but it is also a nice dividend payer as well. Shares currently pay out $1.88 per year, good for a current yield of 2.1%, making HD a market-level dividend payer. This is nice as it helps boost total returns for the stock and also helps buoy shares in down markets. However, there is likely upside to the dividend over and above what I've shown in the model.

HD's two most recent dividend increases were 34% and 21%, respectively, indicating there is still huge upside to HD's ability to grow the dividend. If HD increases the dividend at more than a 6% rate, which I feel is a virtual certainty, we should see additional upside to the fair value of shares once adjusted for the higher dividends. This doesn't even mention that this is cash that is returned directly to shareholders in the process. So not only do you get terrific fundamentals but HD is a real dividend growth story as well.

Right now I love HD shares. Even though they are trading at all-time highs following the earnings beat there is still a lot of value to be seen here. With shares at roughly 17 times next year's earnings they aren't cheap on a traditional valuation basis but I think there is upside to those estimates. HD has been driving unbelievable earnings momentum and it did nothing but accelerate that momentum in the latest quarter. The increased buyback will also boost earnings going forward as HD retires 6% of the float in 2014. Finally, the company is quickly becoming a dividend growth story and I also believe there is upside to my dividend growth rates used in the model, producing further upside in not only the fair value but total returns over time as well. What more could you ask for?

Source: Home Depot: Dividend Growth And Impeccable Fundamentals