One of the most troubling aspects of the stock market is that it is presently at its third priciest point in all of stock market history, and HD stock is a great example. The market at the turn of the century was more expensive, and the market back in the days pre-1929 was the second highest. The challenge, then, is trying to find a reason to buy a wonderful company like Home Depot Inc (NYSE:HD) when it’s right on the edge of what I am comfortable with from a valuation standpoint.
With my stock advisory newsletter, The Liberty Portfolio, I take an extremely risk-averse approach to buying equities. Generally speaking, if a company that is growing net income at a rate of 15% annually or under, then it must have a PEG ratio of 1.0 or under to consider buying (possibly as high as 1.20 depending on circumstances). I take the growth rate, add the dividend rate, and then offer a 10% premium for each of the following: sizable net cash position, sizable and consistent free cash flow, and world-class brand name. Then I take the stock price and base the P/E ratio on the company’s stock price net of net cash.
For stocks with 15% or higher annual growth in net income, I’ll give up to a 2.0 PEG ratio. HD stock is right on the cusp.
A Closer look at HD Stock
Certainly, HD stock is a blue-chip company and world-class brand. It also has exceptional free cash flow, although it has $20 billion in net debt.
Home Depot, along with large competitors, has become a default stop for those seeking hardware supplies. When a company enters the lexicon as its own thing, you know it is a global brand name. Raise you hands out there if you say, “I’m going to the hardware store.” Nope. You say “I’m going to Home Depot [or competitor].”
So that, plus its continuing rising free cash flow – from FY14 of $6.8 billion to FY15 of $7.83 billion to FY16 of $8.16 billion – gives it a 20% premium.
Now, let’s examine some recent earnings reports. The single most important metric to me, other than cash flow, for any retail company is comparable store sales. This metric shows the extent to which consumers return to the same location to buy more stuff (or if the company has pricing power by keeping traffic steady but increasing prices).
Wouldn’t you know it, but in Q2, HD stock came in with 6.6% comp increases in the U.S. This is unreal for a company that has been around this long. Even better, the 6.6% was about evenly divided between price increase and traffic increase. The result was the highest quarterly revenue take in company history at $28.1 billion. Think about that. It means HD stock rakes in about $129 billion in revenues every year. That’s almost as much as Amazon.com, Inc. (NASDAQ:AMZN).
Don’t Sweat Amazon
For anyone worried about Amazon moving into home improvement in a big way, I don’t think it’s going to happen. That’s because home improvement projects are what I call “now” projects. People don’t buy bulky items online because they are a pain to ship and receive. Moreover, though, when people decide to do a project, they want to see and feel what they are buying. They want to match colors. They want to get a close look at what they are installing. Amazon can compete on small things like tools, but that’s about it.
So HD stock is pegged to grow net income 13.25% in FY18. Add the 2.25% dividend. That comes to 15.5% growth. Add in a 20% premium per the above, and I would be comfortable with a PE ratio of 18.8. HD stock trades at 22.4x TTM net income.
The PEG ratio is thus 1.19. I think this puts it right on the cusp. If you are looking to hold HD stock for a very long time, at least ten years, you could buy here. If you are looking at a shorter-term horizon, or you think it’s too expensive, wait for a pullback.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
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