What’s the opportunity in Home Depot?

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If I can, I try to build in most investing lessons I have to share into examples using individual stocks. Sometimes, I’ll start with the concept in mind and then locate a good individual stock to use as an example, and sometimes I begin by examining an individual stock and then zoom in on an aspect I think is important which can also apply to other stocks in a similar position. One important concept that usually comes up in the comments of of my articles is what each investor’s return goals are (though seldom does it come out in the open). One’s return goals are an important aspect that isn’t often given the proper attention. In this article, along with sharing my standard valuation process that I use for Home Depot (NYSE:HD) stock, I’m also going to briefly discuss return goals and how they can influence how to treat the valuation of a stock such as Home Depot. I’ve only written about Home Depot once before back in 2019, when I rated the stock with a “Hold”. The stock has been roughly equivalent to that of the S&P 500 since then so that was probably a reasonably correct review when I wrote it.

My method of valuing has become more precise since mid-2019, but in the end, it’s still largely similar. Basically, what I do is determine, using the combination of P/E and reversion rates, as well as earnings yield and expectations of earnings growth, what sort of long-term CAGR could we expect for Home Depot stock if purchased at current prices and held over a period of 10 years. This is then used to calculate a rough CAGR estimation to gauge the value of the stock against my goals for return to determine what price I’d be willing to buy it.

This article will cover three things. First, I will run through my usual valuation process to determine the value of Home Depot stock. Next, I’ll look at some adjustments that I think would be reasonable to take into consideration in this estimate. In the final section, I will discuss how investors’ objectives for return will be reflected the time when Home Depot stock looks attractive as an investment. I’ll also provide a dividend analysis as well.

Let’s begin with the basics of analysis.

How Cyclical is Home Depot’s business?

Before beginning the analysis, I review the company’s earnings patterns in order to make sure that the company is the right fit to conduct this type of analysis. In the event that the historic earnings 1.) aren’t backed by a long enough time span,) are not consistent in nature, or) tend to be too seasonal, then I either don’t analyze the stock in any way or use a different type of analysis that is more suitable to the company.

In the past 20 year, Home Depot has grown its earnings per share in each year, excluding the three years of the great economic crisis of 2007, 2008 and 2009. In the total of those three calendar years Home Depot’s earnings growth decreased by a bit more than -40%. My general rule of thumb when deciding whether to label a company to be a “deep cyclical” company is the fact that earnings generally fall by -50% or more during downturns. Therefore, I wouldn’t consider Home Depot a “deep cyclical” stock. But, it has a moderate to deep earnings cyclicality historically, and since the 2020 recession was unusual in its scope and we haven’t been in an “normal” recession since 2009, it’s crucial to realize that if there is a recession, the growth of Home Depot’s earnings will likely be negative. The odds aren’t the same as 2007-2009 however the majority of analysis being conducted in the present (including the fundamental analysis I’ll begin on in this piece) likely won’t factor in the kind of earnings decrease into their long-term earnings growth calculations. But, it’s fine to make that adjustment at some point in our analysis, it’s okay to employ my usual “Full-Cycle Analysis” when dealing with this issue, so that’s what I’ll do in this article.

Market Sentiment Return Expectations

To determine the type of returns could be expected in the coming 10 years, let’s begin by looking at what kind of return we could anticipate in 10 years’ time if the P/E multiplier was to return to its mean from the prior economic cycle. Since we have had a recent recession (albeit not a typical one) I’m beginning this period in fiscal year 2015 and will continue through 2023’s forecasts.

The average P/E of Home Depot from 2015 to the present has been about 22.35 (the blue bars that is circled by gold is shown on FAST graphs). If we take 2023’s forward earnings estimates of $16.55 (also indicated with gold), Home Depot has the current P/E at 17.71. If the 17.71 P/E was to fall to the average of 22.35 over the course of the next 10 years, and everything else were kept the same, Home Depot’s value would rise and it would produce a 10-Year CAGR of +2.34%. This is the annual return we can expect from sentiment mean reversion, assuming it takes 10 years to reverse. If it takes less time to convert and return, the rate would be higher.

Business Earnings Expectations

We looked at what could occur if market sentiment reversed to the norm. It is completely determined by the mood of the market and is usually not linked from, or even less connected, to the performance of the actual business. In this article we will analyze the actual income of the company. This is the goal It is that we would like to know how much we would earn (expressed in terms of CAGR percentage) over the course of 10 years if we bought the business at today’s prices and kept all of the profits for ourselves.

There are two key elements of this: the first is the earnings yield and the second one is the speed at which the earnings could be expected to grow. Let’s start with the earning yield (which is an inverted P/E ratio, so the Earnings/Price metric). The current yield for earnings is around +5.64%. My preferred way to think about this is, If I were to buy the company’s entire operation right now for $100, I would be earning $5.64 annually on my investment if the profits remained unchanged for the coming 10 years.

The next step of the Home Depot stock forecast is to determine the company’s earnings growth during the period. This is done by figuring out at what rate earnings increased in the last cycle and applying that rate to the subsequent 10 years. This is done by calculating the EPS increase since 2015 by taking into account the EPS growth rate for each year or decrease, then taking out any share buybacks that occurred in the time frame (because reducing shares will increase the EPS because of fewer shares).

Home Depot has repurchased a significant amount of stock in the last 20 years (ironically, except when the price of its stock falls significantly during recessions, such as in the year 2008 and the year 2020) and the buybacks have resulted in an EPS that has been steady and fairly high growth. Since 2015 alone, they have purchased around 1/5th the company. I will back these buybacks out when estimating earnings growth. When I do that, I have an earnings growth estimate of +14.93 percent from 2015.

Then, I’ll apply the growth rate to current earnings and then look forward to 10 years in order to get an estimate of the 10-year CAGR. The way I look at this is: should I purchase Home Depot’s whole business for $100 and it paid me in $5.64 plus +14.93 percent growth in the initial year, and that amount will grow at +14.93 per year for the following 10 years. I want to know how much money I would have in total at the end of 10 years from the $100 investment that I calculate to be about $230.96 (including the original $100). When I plug that growth into a CAGR calculator, it will translate to an +8.73% 10 year CAGR estimate of the expected profits of a business.

10-Year, Full-Cycle CAGR Estimate

Future returns for potential investors can come from two primary sources either from market sentiment returns or business earnings returns. If we believe that sentiment in the market returns to its mean from the last cycle for this period of time for Home Depot, it will yield a +2.34% CAGR. If the growth and yield on earnings are similar to last cycle, the company should produce somewhere around a +8.73 percent 10-year CAGR. If we take the two together, we’ll have an estimated 10-year, full-cycle CAGR of +11.07 percent at the present price.

My Buy/Sell/Hold tier for this class of stocks is: Above 12 percent CAGR is considered a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. This leaves Home Depot undervalued, and currently an “Hold” however, it is close to my buying threshold of 12%. Moreover, If the price dropped to $277 or less, it would cross that threshold for buying. But I’m of the opinion that my base analysis here is extremely optimistic due to a number of reasons that I’ll discuss in the following section.

Additional Requirements

Whenever a stock gets close to my standard purchase price, I try to place my beliefs under more scrutiny. Usually, this means expanding the scope and asking whether my basic assumptions are fair or not, as well as evaluating any potential risks that might not be built in those assumptions.

The first sign of caution to investors could be that the analysts covering the stock are predicting 6 to 7 percent growth in earnings per share in the fiscal years 2023, 2024 and 2025. And this likely includes the effects of buybacks of stocks. In other words, if we remove the buyback analysts should believe that they will see 5% organic profit growth going forward. This is about 1/3rd of the growth rate since 2015, which is the number I used for my initial analysis of the stock. I can’t emphasize enough how rare it is to observe this kind of conservativeness from analysts when the growth rate of earnings has been so impressive. But, if we take a closer look and apply the context of this, then I think this kind of conservative estimate is logical.

Then, from the fiscal year 2015 through the year 2018, EPS growth steadily declined from 22 percent to 16% (even more if you remove the buybacks). However, in calendar year in 2018 (fiscal 2019), we had corporate tax cuts that was a huge boost to Home Depot’s revenue increase that year. Although EPS rose 33% during this year, revenue was up 7.23 percent.

Thus, this 33 percent EPS growth year in fiscal 2019 could be an outlier in EPS growth for the year.

Then in fiscal 2021 and 2022, we saw massive stimulus from the government and an exodus of people from cities towards suburbs and countryside. This could result in two additional years of unusually large EPS growth, whereas the years between witnessed a 4% increase in EPS. When you look at it all in context I believe analysts’ predictions for the coming 3 years of EPS growth are likely to be sensible estimates.

If I had to employ an estimated 7% growth rate as opposed to the +14.93% assumption for my fundamental analysis, I’d be able to calculate an annual CAGR of +8.13 percent, which is right at the middle of fair value to me, even if all other variables were kept constant, and much farther away from being an “buy” for me in my book. But slower growth in earnings isn’t all there is for the stock. Home Depot stock.

The additional danger is that my initial analysis did not include an “normal” recession. The profits of Home Depot fell by -40% from 2007-2009. This was a very severe recession that affected HD’s final customers considerably, and therefore earnings may not decline that much in the next recession. However, I think it’s sensible to assume two years of decline , with an overall decline of -30% during an average recession (which is likely to occur sometime in the course of 10 years). If a recession were to occur in the space of a few years from now and we include it in our estimate of cumulative earnings growth and the growth rate for earnings CAGR for cumulative earnings over the next 10 years would be +2.58%. If we take the earnings growth rate assumption and we calculate a 10-year CAGR expectation of +7.04 percent. Close to fair value, however there are likely knock-on consequences of a growth rate which is slow.

If we are really talking about an earnings growth rate of low-to-mid-single-digits, it’s probably not reasonable to ever expect the P/E to revert back to over 22. For that reason, I think we need to put aside the mean reversion part of the figure. Mean reversion typically can only be counted on for stocks whose earnings are growing at the same pace that they have before. If we eliminate the +2.34 percent mean reversion expectations that we have, then we can get an estimated 10-year CAGR of +4.70 percent that is closer to being a “Sell” than it is an “Buy”. Using these assumptions and removing the mean reversion, Home Depot stock would need be able to fall to around $138 per share before it could be considered a “buy” for me.

Dividend Payback Analysis

Because Home Depot has a pretty long history of paying a regular dividend and seems to have many dividend investors interested in the stock So I decided to include a dividend analysis here too. One benefit of an analysis of dividends is that it is likely for dividends to keep rising over the next decade regardless of whether earnings growth slows , as I believe it to. Additionally, based on the I believe regarding recessions and earnings, my standard analysis can yield an array of outcomes. A dividend analysis may allow us to alter our perception of which point of the spectrum makes the most sense.

Thoughts on Returns Thresholds

Let’s see, I’ve analyzed Home Depot stock from a range of angles and it appears like somewhere under 150 cents per share or around 50% of the price it trades at, it could be low enough to convince me to consider buying. I’m sure a lot of investors who read this article believe that Home Depot stock will never drop that low. To that, I have a couple of points to make. First, I believe that my “buy prices” are not typical “price targets” that analysts offer. It is not my intention to predict that Home Depot stock will necessarily be that low. What I’m saying is if it does fall this low, I’ll most likely buy the stock. I don’t have a jar of cash marked “Home Depot Stock” which I’m waiting to invest in Home Depot that will go to waste if it doesn’t reach the value I’m trying to find. Instead, I have a pool of cash, and I monitor approximately 600 stocks daily to determine if any of them hit my buy prices. Given the amount of money I’m currently holding and if I can find 30-40 percent to hit from the 600 over the next two years then I’ll be in very good condition.

This doesn’t mean that everyone has to have the same buy prices I do. It’s just that one buy price is correct while another one isn’t. This is where the return objectives and expectations become relevant. Assuming we don’t have an inflationary or depression, my objective is to attain overall portfolio returns that range from 15% to 20% per year , on average, over the long term. This is roughly 50 to 100% better than the average long-term performance that are part of the S&P 500 index and about 25% or more lower than the long-term returns for Berkshire Hathaway. Because I’m seeking higher returns, I pretty practically have to purchase stocks when they’re inexpensive. Additionally, I’ll need to determine very profitable long-term investors early. Additionally, I must know when we are at the top of an economic cycle, or at the bottom. It is my goal to accomplish every one of them, none of which are particularly easy for an average investor to do.

However, there are many investors who aim for these high returns. Certain investors simply want market returns, and so they index. Some investors are more concerned about the earnings generated by assets and not on the asset prices , so they focus only on dividends and income. There are investors who are thrilled to point out that their dividends return an average of from 7% to 8% annually. Personally, I’m not among these investors. In the first place, I don’t mind whether the returns I earn are from capital gains or dividends or whether they are actually realized or not. I’ll be taking the profits however I get them in. But under normal circumstances, I want 15% to 20% annual long-term returns. Most investors do not aim for such returns.

This creates a situation where if we think of the market as basically an auction for future returns. The auctioneer starts off the bidding at an annual rate of 1% for each stock. The auctioneer after that, if there’s no bidders raises the return to 2%, and so on until all of the stocks that are on the market are sold every day. Even if everyone was aware of exactly what the future return would be, based on the investor’s required return, they could be able buy a share on the same day or it could be impossible if all stocks are sold before the return requirement is met. If there are lots of investors willing to settle for low future returns, then someone like me might not get the chance to purchase something with the high future returns I’m hoping for. However, we do not know what the future returns are likely to be for any given stock, so, combined with external economic conditions along with the fact a lot of investors limit themselves to certain kinds of stocks (like dividend-payers, fast growth, tech, or non-cyclical ) or U.S. stocks …), and the fact that many traders don’t focus on long-term returns at all, is that every once in a while, I have the chance to purchase stocks with a high chance of returning. But, I’m in the hands of other investors who will be willing to accept a lower rate of return than I can. That’s just the way it is.

My point here is that as long as we’re dealing with an outstanding business likely to provide a return in the long or medium-term similar to what we have for Home Depot, there isn’t necessarily a “wrong” cost to buy it at. Should an investor be pleased with the 2.51 percent dividend yield that increases at 11% each year over the next 10 years and meets their expectations, then more than they deserve for wanting to buy the stock. I’m just aiming for higher returns than this. Therefore, I’ll wait.

Conclusion

Much about Home Depot stock’s performance over the next three years will depend on whether we are in a bear market and a recession or not. I think the odds of a recession are high which is why I think my base-case for the stock is that it falls further between -30% and -35 percent from now at some point over the next few years. If it falls more than -50% then I’ll be buying. I don’t believe Home Depot is much more overvalued than the overall market, though, and even if we do not experience recession, even though the return won’t be that great, the stock will likely be able to do just fine. Therefore, I’m grading the stock as with a “Hold” here even though I believe there are some risks that aren’t being priced into the stockat this time since stocks with similar characteristics aren’t much more expensive in comparison to Home Depot at the moment and it’s hard to judge the extent of a recession might be even should it happen.