While I am attracted to Home Depot (HD) due to its strong and competitive strengths against Lowe's (LOW), the low beta limits high risk-adjusted returns. I believe that the economy will return to full recovery sooner than what the market acknowledges and that the riskiest stocks will outperform as a result of overly high discounting. In this article, I employ a DCF model to value Lowe's and Home Depot and then triangulate the result against a review of Sears (SHLD). Despite the bearish sentiments on Sears, I believe that the company could actually outperform Home Depot and Lowe's in near future.
To value Home Depot, I make several assumptions: (1) 14.6% per annum growth over the next half decade, (2) operating metrics stay at historical levels, (3) a 1.5% perpetual growth rate, and (4) a 10% discount rate. Based on these assumptions, I find that the stock is worth right around its current market value.
All of this falls within the context of strong performance:
While northern regions benefited from a strong seasonal business and an easy compare in the first quarter, we were also pleased with the positive performance in southern and western regions where the weather was more normal. Total transactions grew by 3.9% while average ticket also increased 2.2% for the quarter. Transactions for tickets under $50, representing approximately 20% of our U.S. sales, were up 2.4% for the first quarter. Transactions for tickets over $900, also representing approximately 20% of our U.S. sales, were up 6.7% in the first quarter.
From a multiples perspective, Home Depot trades at a respective 19x and 14.3x past and forward earnings versus 20.1x and 12.5x for Lowe's .
To value Lowe's, I make several assumptions: (1) 7% per annum growth over the next half decade, (2) operating metrics stay at historical levels, (3) a 2.5% perpetual growth rate, and (4) a 10% discount rate. Based on these assumptions, I find the fair value of the stock to be $33.81 for 18.7% upside. The stock is a little more volatile than the broader market and offers a dividend yield of 2%, which makes it relatively more likely to recover lost shareholder value since the beginning of May.
A true high risk / high reward can be found at Sears. It is around 100% more volatile than the broader market and has a large 52-week range of $28.89 and $85.90 - the latter of which is three times the former! Perhaps most interestingly, the trough and peak occurred within slightly less than three months this year. Consensus estimates forecast losses at least over the next three years with EPS being -$2.94 in 2013, -$3.61 in 2014, and -$3.02 in 2015. The Street currently rates the stock around a "sell" (source: NASDAQ). With the bearish sentiments overwhelming the company, I recommend possibly day trading off of the swings. In fact, a large reason the company was able to reach its recent peak was due to the CEO releasing a turnaround plan. Any signs of momentum and loss mitigation would significantly appreciate shareholder value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.