Has anyone heard about what is happening in the retail sector? I am sure you have but have you heard about how Home Depot (HD) is bucking the retail trend? HD has had an impressive run having doubled its share price since 2014. The last time that HD missed its EPS and revenue estimates was Q1 2014. HD appears to be firing on all cylinders but where does that leave its valuation? This article will derive an estimated fair value for HD.
WHERE ARE WE AT?
First, letâ€™s take a look at some of the current valuation metrics. HD current price to earnings ratio is 23.1. YCharts reports that the 5-year average is 22.4 while Gurufocus.com shows that HDâ€™s 10-year median PE ratio is 19.6. The industry median is 20.7x while the market is 23.6x. All of these indicators suggest that HD is overvalued compared to its historical norm and the industry.
In his recent article, Chuck Carnevale uses the earnings yield to quickly determine the valuation of a stock. The earnings yield is calculated by taking the current earnings dividend by the stockâ€™s current price. Chuck feels that any value below 6% means that the stock is overvalued. In the case of HD, the TTM EPS is $6.71 and the current price is $153.99. The earnings yield is 4.4% which suggests that HD is overvalued.
The infographic below further shows that HDâ€™s PEG ratio is 2.0x which is considered poor value based on next yearâ€™s expected growth and that its price to book ratio which is 47.4x is overvalued based on its assets when compared to the retail industry average. Furthermore, the EV/EBIT is 15.17 and the P/FCF is 21.04. Putting this together, HD is overvalued on all fronts.
Source: SimplyWall.St
At present, there are 20 analysts with buy ratings, 2 with outperform ratings, and 9 with a hold rating. There is no sell or underperform ratings which is a bullish sign. The current consensus among the 31 analysts is obviously to buy HD and that this rating has held steady since November 2016.
Based on the above findings, HD appears overvalued but analysts remain quite bullish on the future of HD. That leads us to the next section.
WHERE ARE WE GOING?
The infographic below shows what analysts are predicting as HDâ€™s earnings per share over the next few years.
Source: SimplyWall.St
HDâ€™s EPS came in at $6.45 in FY2016. Management has issued its EPS guidance for FY2017 of $7.15. Analysts are estimating a FY2017 EPS of $7.24 (range of $7.16 to $7.37), FY2018 EPS of $8.18 (range of $7.95 to $8.98) and FY2019 EPS of $8.92 ($8.59 to $9.20). This represents year over year growth of 12.25, 12.98%, and 9.05% respectively. HD continues to see increasing sales and positive comps year over year and quarter over quarter. Management has also raised its EPS guidance of $7.13 from Q42016 to the present $7.15. Analysts are probably expecting continual upward revisions since their estimates at $0.09 higher than managements. HD future 5-year growth estimate is 12.98% which is well below its past 5-year growth rate of 20.30%. This is also below the industryâ€™s long-term growth rate estimate of 18.60%. This demonstrates that HD is lagging behind in its industry and that its growth is slowing.
If analystâ€™s estimates are accurate, then HD is currently trading at 21.3x FY2017 earnings, 18.8x FY2018 earnings and 17.3x FY2019 earnings. These PE ratios are all below the 5-year average and the 10-year median which may present a tempting entry price for future earnings. If I use the 5-year PE ratio, based on HDâ€™s EPS estimates, the stock would be trading around $162.18 in FY2017, $183.23 in FY2018 and $199.81 in FY2019. This suggests that HDâ€™s current stock price could be undervalued by 5.32% if the stock were to be trading around $162.18. This suggests that the stock market has the price about right but is likely volatile due to the retail sector troubles.
Over the next 12 months, analysts are estimating that HDâ€™s median price estimate will be $175.00 which represents 11.7% upside from the current price. The range runs from a low of $152.00 (3% downside) to a high of $182.00 (16.2% upside). This shows that there is little downside risk to HDâ€™s share price (if estimates hold true) while the upside potential is much greater. This is a favorable risk/reward argument.
IS HOME DEPOT TRADING AT FAIR VALUE?
I used a reverse DCF to determine how much the market expects HDâ€™s growth rate to be. With shares trading at $153.99, the market is pricing in earnings to grow at 14.81%. This is slightly above the 12.98% analysts are estimating over the next 5-years.
An EPS growth rate of 14.81% would translate into an EPS of $7.41 in FY2017. This does exceed the highest analyst EPS estimate of $7.37 and is well above managementâ€™s guidance. It appears that the market is stretching its expectations for HD.
What is my fair estimate for HD? To answer this question, I calculated the fair value of HD using three models: Discounted Cash Flow, Grahamâ€™s Formula, and EBIT multiples.
The inputs I used for the DCF was a growth rate of 12.0%, a discount rate of 8.57% based on the work of Prof. Damodaren's rates for each industry, a terminal rate of 2% and a starting FCF value of $8.16B. This provided a fair value estimate of $130.26.
The inputs I used for the Graham's Formula include a growth rate of 12.0%, and EPS estimate of $7.24 and a 20-year AA corporate bond rate of 3.56%. This provided a fair value estimate of $170.02.
The inputs I used for the EBIT model has a conservative, normal and aggressive case. Based on HD's past 5-year EV/EBIT history, I chose a multiple of 14.28x for the conservative case, 14.7x for the normal case and 15.17x for the aggressive case. Revenue estimates were $99.28B in each case. This resulted in fair value estimates of $145.94, $150.67 and $156.01 respectively.
The table below provides a summary and calculations of the estimated fair value of HD.
Current Price | DCF | Graham | EBIT (Normal) | Historical PE | Analysts Estimate | Average FV | Median FV |
$153.99 | $130.26 | $170.02 | $150.67 | $162.18 | $175.00 | $157.63 | $162.18 |
Source: Old School Value
Based on these calculations, the average fair value estimate is $157.63 and the median fair value estimate is $162.18. Based on todayâ€™s stock price, HD is currently undervalued by 2.36% or 5.32%.
Below you will find my risk/reward chart based on the long-term growth rate (12.00%) and the average and median fair value estimates. The red and green lines in the price action chart below represent the trading range of HD based on that growth rate. Obviously, when the stock is near the top line, it is not the time to buy and when it is near the bottom line, it is time to consider buying.
Source: Freestockcharts.com (daily view)
Source: Freestockcharts.com (weekly view)
As you can see in the daily view chart, HD is in the buy price box. The gray box shows the average fair value as the upper buy limit. Drawing this risk/reward chart was difficult. I found that the lines of best fit suggest a growth rate of 23.6% which is nearly double what analysts are estimating. Obviously, this is not likely. But I suggest that if I could, I would begin to round out the lines. The reason for this is because I believe that the growth of the company following the great recession has influenced the lines and does not reflect the slowing growth compared to years past. There was also a great deal of enthusiasm with the election of President Trump because of his infrastructure spending plan which raised many home builder and supplier stocks. HD definitely was one of them. Here is a quick table to show various margins of safety based on the estimated fair value.
Average FV | $157.63 | Median FV | $162.18 | |
Margin of Safety | 5% | $150.12 | 5% | $154.46 |
10% | $143.30 | 10% | $147.44 | |
15% | $137.07 | 15% | $141.03 | |
20% | $131.36 | 20% | $135.15 | |
25% | $126.10 | 25% | $129.74 |
CONCLUSION
Based on this analysis, I consider HD to be fairly valued at its current price since the margin of safety is minimal. If the stock were to pull back 25%, it would result in a dividend yield of 2.82% which is quite desirable. At the moment, the stock price is also bumping up against the upper risk/reward line which could lead to a possible pull-back. I would wait for a pull back because of the lack of a margin of safety. On a side note, a 25% pull-back would touch the green or lower risk/reward line.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.