I don’t want to rain on anyone’s parade, but the market is now at its third most expensive in history, save the 2000 dot-com bubble and 1929. That means that even though stocks like Home Depot Inc (NYSE:HD) are doing very well, it also means that I believe HD stock and many others are far, far too high.
How high? Well, let’s get some perspective first. HD stock is a premier company. I consider it to be a blue-chip, in that it is a company that will be around for a long time, has very consistent growth and cash flow, and survived the financial crisis with good management.
It isn’t just that Home Depot became a “category killer”, it’s the concept that it became a go-to choice for hardware. Sure, there are competitors, but the days of the neighborhood hardware store are long gone. You don’t say, “I’m off to the hardware store to pick up some widgets”. You say, “I’m off to Home Depot to pick up some widgets” (or whatever big box hardware store in nearby). The brand name itself has replaced the generic term.
Thus, the company has all of these things going for it, which is why I believe HD stock deserves a premium.
Home Depot Stock Is Doing Well
If we take a look at the last fiscal year’s numbers, the story is encased within. When it comes to retail stocks like this, the single most important metric outside of cash flow is comparable store sales. It is the only true measure of organic growth, and Home Depot comps came in at 5.6%.
That’s a solid number. Anything above 4% is a solid number. In fact, 5.6% approaches “great”. Digging further, the number of customer transactions increased 2.9% and the average ticket increased 2.7%. Thus, more people came into HD than they did the previous year. That means Home Depot stock either stole market share from competitors, or more people had disposable income and they deliberately chose to spend it in its stores.
Even better, HD stock guided for a 4.6% comp sales increase for FY17. So the expectation is that this trend will continue.
Other great news is that net income grew 13.5%. Now, that’s important because it’s actual cash net income, not earnings-per-share, which can be juiced by buybacks. Not only that, this increase comes on the heels of a 24% increase in debt service to $936 million. So even though interest payments went up by $183 million, Home Depot stock still delivered a $948 million increase in net income.
Bottom Line on HD Stock
Add in the fact that free cash flow grew again to $8.16 billion, and that the dividend (which was raised) is only $3.4 billion, we can see that the $22 billion in debt carried means very little as far as it being any kind of drag.
So with about $8 billion in net income for the year, the problem arises when we look at valuation. At $180 billion market cap, HD stock trades at 22.5x net income.
And that, my friends, is where the problem lies.
A company growing net income at 13.5% annually is a very solid play to begin with. I even give it that brand premium, which I set at 10%. I give it another 10% premium for its consistent and strong free cash flow. So one might argue that a 16.5x valuation is reasonable.
I might even be willing to bump it to 18x or even 19x. But at 22.5x, HD stock is just way too expensive. To get it down to even 18x would mean a market cap shave of 20%, or about $30 per share. So for now, I suggest staying away, but wait for a big correction.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities.