Over the last six months, Lowe's (NYSE:LOW) and Home Depot (NYSE:HD) have appreciated by 34.9% and 36.7%, respectively. I find that they are still undervalued as the economy moves, albeit slowly, towards full employment. In this article, I will run you through some growth assumptions on Lowe's and what they mean for shareholder value.
In my DCF model on Lowe's, I make several assumptions: (1) 7.5% - 5% per annum growth over the next six years, (2) operating metrics in-line with historical metrics, (3) a perpetual growth rate of 2.5%, and (4) a discount rate of 9%. Based on these four assumptions, I find the fair value of the stock to be $40.45, implying 33.3% upside.
Perhaps the most important aspect to consider when implementing a DCF model is the sensitivity. My sensitivity analysis (which considers a variety of perpetual growth rates and discount rates) finds a standard deviation of $6.08, which is around 15% of my price target. Put differently, the company is not very sensitive to my assumptions. If we assume an 8% per annum growth rate over the explicitly projected time period, for example, fair value comes out $44.57, which is only 10% higher than what is expected for the 7.5% - 5% explicit per annum growth rate.
Ultimately, I find that the company is worth 12.2x my 2016 free cash flow projection. All of this falls within the context of strong overall performance:
Sales for the fourth quarter increased 11%, including the 53rd week, while comparable store sales were positive 3.4%. Comps were positive in all regions of the U.S., as well as in 13 of 16 product categories. Comp transactions increased 3.8% in the fourth quarter and comp average ticket decreased 0.4%. While gross margin contracted largely in line with our expectation, we had good operating expense control and delivered earnings per share of $0.26, exceeding our guidance for the quarter.
Delivering on our commitment to return excess cash to shareholders, in the fourth quarter, we repurchased $500 million or 20.7 million shares and paid $177 million in dividends. Overall, I'm encouraged by the progress we made in 2011 toward delivering better customer experiences and transforming our business to drive long-term sales growth and increased profitability and shareholder value.
From a multiples perspective, Lowe's comes across as an attractive growth stock. It trades at a respective 21.4x and 13.4x past and forward earnings versus 20.2x and 15.3x for Home Depot.
Home Depot has shown a competitive edge over Lowe's with the latter closing stores nearest to its competitor. While Home Depot is a safer pick, it has less of a value gap at this point. (1) Factoring in a 14.6% per annum growth rate over the next six years while (2) holding operating metrics at historical levels, (3) assuming a 2.5% perpetual growth rate, and (4) discounting backwards by a WACC of 9% yields a fair value figure of $62.79 for 25.3% upside. Home Depot has considerably less capex than Lowe's at the current moment and only trades at around 10x my 2016 free cash flow projection. With the stock offering a dividend yield of 2.3% and much lower volatility than Lowe's, Home Depot is better for risk-averse investors. For value investors, however, this is a greater discount to intrinsic value at Lowe's.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.