There is no denying that Home Depot Inc (NYSE:HD) is one of America’s greatest success stories. With the right vision, proper execution, and enough capital, the company took the idea of the neighborhood hardware store and blew it up to massive scale.
HD stock has done extraordinarily well over the decades. It was particularly impressive that, during the financial crisis, HD was able to stay afloat because it still made money, had plenty of free cash flow, and a balance sheet that could withstand a prolonged downturn.
HD Stock Is Likable
HD stock is a stock I would like to personally own for the long-term, but its valuation has generally been problematic for me. When it comes to deciding if I want to buy into a stock as a value play or a growth play, my rough estimate is based on the PEG ratio.
Companies that increase annual net income at less than 15% are now what I consider a pure growth stock. It’s obviously a company doing well if the growth rate is over 10%, but that 15% threshold is about where I make a judgment regarding what I’ll pay.
So I will buy a stock with a growth rate under 15% if its PEG ratio is 1.0 or less. I do have some adjustments, which I will start with a base growth rate based on analysts’ 5-year annualized growth rate estimate and add the dividend yield to that. I also permit up to three premiums of 10%, based on whether 1) the company has a truly world-class brand, 2) a massive cash hoard, or 3) very high free cash flow.
For stocks whose net income is pegged to grow at 15% or more, then I’ll permit a PEG ratio of up to 2.0.
We start with growth estimates, which are 12.57%. I add the dividend yield which is 2.23%. So we are at a total so far of 14.80. Yes, HD most certainly is a world class brand, so I’ll give it a 10% premium, taking us up to 16.28.
Free cash flow is terrific. In fact, HD stock keeps a tight and consistent lid on capex, which is running between $1.44 and $1.62 billion annually. FCF has been growing each year, from $6.79 billion in FY14 to $7.79 billion in FY15 and then o $8.2 billion in FY16. So add in another 10% and we get to 17.76.
It has a good cash position with $2.54 billion but it is offset by over $20 billion in debt.
Thus, with TTM net income of about $8.4 billion, I’d be willing to give it an 18x multiple. However, it presently trades at a 23.5x multiple.
This tells me that HD stock is way too expensive right now. However, a 20-25% decline in HD stock price to about $120 or so and we have a winner.
That leads me to ask how the overall business is doing these days. I want to make sure that there aren’t hidden problems. We know operational and free cash flow are increasing, and that is fantastic.
But I want to know about comparable store sales. That is truly the best piece of information that any investor can have about a retail operation. In its most recent quarter, Home Depot reported great numbers.
Bottom Line on HD Stock
I was very impressed – VERY impressed – that it delivered same store comps of 6.5%. Of that, it was roughly split between increasing traffic and increased prices. The reason this is so significant is that, first of all, on an average basis, 3.3% more people came into a Home Depot store than the same time last year. Either they came from a competitor, which is good, or the economy is improving so that people are spending more money, which is good.
The second great thing is that HD retains pricing power.
So, at this point, I am content to wait it out. I wouldn’t sell HD stock, though. It’s a long-term keeper.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at http://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.
