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Home improvement stocks are trading up 9.6% over the past month, outperforming the S&P 500 by about 6.2%, according to TickerSpy's index. The rise has largely been due to macroeconomic improvements seen in the U.S. economy, but the sector's average price-earnings ratio now stands near the S&P 500 level at 22.8x its trailing 12-month EPS. So, is the sector now fairly valued or poised for a move even higher?

Stocks included in Tickerspy's index include:

  • Beacon Roofing Supply Inc. (BECN)
  • Builders FirstSource Inc. (BLDR)
  • Blue Linx Holdings Inc. (BXC)
  • The Home Depot Inc. (HD)
  • Lumber Liquidators Holdings Inc. (LL)
  • Lowe's Companies Inc. (LOW)
  • Tractor Supply Company (TSCO)

At-Market P/E Ratio Doesn't Reflect Future Growth

P/E ratios are a great way to compare the valuations of two stocks that are expected to grow at the same rate moving forward. But, they aren't very good at valuing differences in growth, which is why many investors use the price-earnings to growth ratio instead. The PEG ratio takes growth into account, with a reading below 1.0 indicating undervaluation in most cases.

Home improvement stocks may have P/E ratios that average 22.8x now, but stronger year-over-year earnings growth will drive that multiple lower in the future if the market improves. And evidence of that improvement is piling up. Last month, furniture sales grew 8.3% year-over-year, according to Census Bureau data, while home sales sold at their highest annual rate in two years, according to the National Association of Realtors.

Here are the current and forward P/E multiples for the profitable companies in the group:

Company

Market Cap

P/E Ratio

Forward P/E Ratio

BECN

$1.18 Billion

17.44x

15.60x

HD

$74.74 Billion

19.84x

15.18x

LL

$677.22 Million

25.99x

17.90x

LOW

$37.55 Billion

21.16x

13.69x

TSCO

$6.18 Billion

28.78x

21.02x

Data from Yahoo! Finance

According to Multpl.com, the S&P 500's current P/E ratio stands at 23.40x, which is significantly higher than many of the current multiples seen above. Meanwhile, the forward multiples seen here are likely conservative due to the recent improvements in the U.S. economic outlook, which means that there's ample room for upside surprise.

Companies & Analysts Turning Bullish

After years of shunning the home improvement industry, analysts are finally turning bullish on the sector. Home Depot and Lowe's were mentioned positively at UBS earlier this month, while even CNBC's Jim Cramer said that the industry is beginning to see a sustainable turnaround (although some investors would see this as a contrarian sell signal!).

Companies themselves are also taking actions that would seem to indicate that a recovery is taking hold. Home Depot recently announced that it's targeting $3.5 billion in share repurchases for 2012, while Lowe's has indicated that it's targeting $4.5 billion in repurchases over the same time frame. Combined, these indicate confidence in strong cash flows moving forward.

How to Capitalize on these Trends

Investors looking to capitalize on the home improvement sector's growth have a number of options. Those that are cautiously optimistic may want to consider implementing a covered call strategy by purchasing large stocks, like HD or LOW, and then writing covered calls against their position to offset their amount of invested capital or perhaps purchasing protective instead.

Those that are more bullish on the sector may want to consider purchasing call options or LEAPS on riskier names, like BLDR or BXC. LEAPS - or long-term equity anticipation securities - are great in particular because they require relatively little upfront capital and offer leveraged returns.

Source: Why Home Improvement Stocks Will Trend Higher