Over the last six months, Lowe's (LOW) and Home Depot (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.
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