The stock market is now the second-most expensive it has ever been and Home Depot Inc (NYSE:HD) is an example of the stretched valuations. So, how does one come up with a thesis to purchase HD stock when its valuation is unrealistic?
What Constitutes a Fair Stock Price?
With my stock advisory newsletter, The Liberty Portfolio, I take an extremely risk-averse approach to buying equities. I refuse to overpay, just like Warren Buffett or Peter Lynch. For The Liberty Portfolio, if I find a stock with net income or earnings per share growing at a rate of 15% or less, then I look for a PEG (price/earnings-to-growth) ratio of 1.0 or less as criterion to purchase (although I might go a bit higher depending on the issue).
Specifically, I use the EPS growth rate, add its dividend yield and, then, provide up to a 10% premium for each of the following:
A) A very large net cash position.
B) A significant and reliable free cash flow.
C) A brand that is known globally.
I generate a P/E ratio based on the company’s stock price and subtract net cash. Then I divide that number by the growth rate.
If a company has more than 15% annualized forward growth in net income, I’ll permit a buy up to a 2.0 PEG ratio. HD stock is teetering on the edge, although its latest results make the choice very difficult using my metrics.
HD Stock Valuation
As for those latest results, they were off-the-charts good — and that’s partially due to the hurricanes. As I’ve long said, the single most important metric when it comes to retail is comparable store sales. That’s because it tells us if consumers return to HD stores over and over again and/or if the company retains pricing power.
I consider good comps to be 3-4%.
HD stock delivered quarterly comps of an astonishing 7.9% globally, and 7.7% in the US. That’s just fantastic. Even better is the fact that 2.7% of this number came from transaction count and 5.7% came from increases in average ticket size.
This led to an overall sales increase of 8.1% to $25 billion, a 10.8% increase in operating income to $3.68 billion and a 10% net income increase to $2.17 billion, or $1.84 EPS on a diluted basis. For the trailing twelve months, net income was $8.6 billion. With a market cap of $197 billion, HD’s TTM P/E ratio is 23.
Analysts see five-year HD stock net income growing at 12.93%. I then add in the 2.17% yield. That brings us to a 15.1 P/E ratio. I also add in a 20% premium per the above criteria, so I think a P/E ratio of 18 would be a reasonable level at which to buy Home Depot stock.
This suggests that, at its present price, HD stock is 20-23% overvalued.
Silver Lining for HD Stock
There’s some good news, though. Amazon.com, Inc. (NASDAQ:AMZN) is going to have a hard time getting into the home improvement sector in any way that is will be problematic for HD stock price. You just can’t buy bulky or large items online because shipping is very expensive and a problem to deliver. In addition, many projects require that contractors and homeowners get their hands on the things they are buying, to see the design, color and shape up close.
My feeling, then, is if you plan to own HD stock for at least a decade, you could buy here and just go to sleep. However, a shorter time horizon for holding HD stock suggests waiting for a (large) correction.
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.
