Why Home Depot Inc Stock Is Finally Too Expensive

Home Depot is doing pretty much everything right, but HD stock looks expensive

Here's How Home Depot Stock Could Bounce Back To $200 This Year

Source: Mike Mozart via Flickr (Modified)

It would seem like a sucker’s bet to go against Home Depot Inc (NYSE:HD). HD stock has rallied 600% from its housing crisis lows, including a 36% gain so far this year. HD stock has outperformed not only the broad market, but rival Lowe’s Companies, Inc. (NYSE:LOW) over pretty much any time period.

Home Depot is the premier brand in a huge and growing category. It has moved almost seamlessly to an “omnichannel” model, dodging the problems that have befallen so many retailers over the past few years.

The company is likely to clear $100 billion in revenue this year for the first time. And Home Depot stock doesn’t look that expensive, at least in this market, with a forward P/E multiple sitting right at 22x, even with HD stock at an all-time high.

Even accounting for all of the positives surrounding Home Depot, however, valuation matters. And the valuation here is starting to look more than a little stretched. Targets from the company’s Investor and Analyst Conference last week suggest solid, but hardly spectacular growth. And the cyclical nature of Home Depot’s business can’t be discounted.

There’s still a case for more upside here, particularly if an investor is bullish on the U.S. economy. But there’s risk, too, and at these prices, I’m skeptical those risks are worth taking.

Is HD Stock Expensive?

Whether Home Depot stock is expensive likely is in the eye of the beholder. A 22x forward P/E offers a substantial premium to LOW, which trades at ~17x next year’s consensus EPS. But Home Depot is outgrowing its rival, posts better margins, and as noted above, historically has been a much better stock.

That 22x multiple is about two turns higher than the S&P 500 as well. HD stock bulls would retort that there are few companies in that index better positioned than Home Depot, and thus that premium is justified.

But that premium also is coming against an index that’s valued as highly as it’s been since at least 2004. In other words, Home Depot is getting a higher valuation than the average S&P 500 stock in an already-rich broad market. So, at the least, Home Depot stock needs further cooperation from the broad markets and the economy.

That reliance does color the valuation here somewhat. Generally, cyclical stocks should see their earnings multiples narrow near the top of the cycle, at least in theory. (In practice, investor psychology doesn’t always work that way as seen in the performance of a cyclical like Caterpillar Inc. (NYSE:CAT) this decade.)

Home Depot’s steady expansion shows that the market doesn’t believe a top for either housing or the economy is on the horizon any time soon. If that’s true, HD stock probably isn’t overpriced. If a top is coming, trouble looms.

Should Home Depot Stock Be Expensive?

Numbers aside, there’s a case that Home Depot stock simply is worth owning. To quote Warren Buffett, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” And by any measure, whether looking at sales and earnings growth or more detailed figures like return on invested capital, Home Depot is a wonderful company.

Meanwhile, much of the company’s core sales go toward repairs that aren’t necessarily based on economic strength. In categories like roofing and plumbing, replacement demand should be relatively steady. A leaky roof or a busted pipe has to get fixed. And so there’s a case that even if Home Depot looks expensive now, it likely always will.

But it’s important to bear in mind that HD stock hasn’t always been bulletproof. Between Jan. 1, 2000 and Jan. 1, 2010, Home Depot stock declined a whopping 57.8%.

Timing there admittedly is a bit unfair. The stock soared amid the 1999-2000 boom (which wasn’t as limited to dot-com stocks as its reputation suggests) and was still climbing out of financial crisis lows at the end of the decade.

Still, the gains of the last six years are simply torrid, even relative to the long-term overall appreciation of Home Depot stock. And, truthfully, they’re a bit of an outlier, and so is the price investors are paying for HD. That seems a potential concern, given the near-term outlook is solid, but not quite spectacular.

Investor Day

Valuation aside, there are risks here. Because renovations tend to be big-ticket items, cyclical exposure remains an issue for Home Depot. Its efforts to move into B2B distribution mean it has to take on Amazon.com, Inc. (NASDAQ:AMZN) in that space, plus seasoned competitors like W W Grainger Inc (NYSE:GWW).

So far, investors have shrugged off those risks, and HD’s performance has even accelerated of late. But I’m truthfully surprised last week’s Investor Day didn’t dampen that optimism somewhat. Home Depot forecast solid growth for the next three years, ranging from 4.5% to 6.0% annually. Those are good numbers but also a deceleration from this year’s expected ~6.6%.

More concerning, margins aren’t supposed to move much, guided to a range of 14.4-15.0% in 2020, against 14.2% last year and 14.9% through the first three quarters of this year. All told, by my numbers, 2020 EPS is guided to a range between $9 and $10.

Even at the high end, investors now are paying 18x+ for earnings three years out — earnings that only are coming if the U.S. economic expansion lasts for a full 12 years. That doesn’t seem like a great bet, and analysts seem to agree, with the target price for HD stock now $188, barely above current levels.

Maybe that’s worth paying. But a lot needs to go right as seen in the company’s own targets. And it would seem that investors betting on that type of economy would have better places to put their money.

As of this writing, Vince Martin has no positions in any securities mentioned.

Article printed from InvestorPlace Media, https://investorplace.com/2017/12/why-home-depot-stock-is-finally-too-expensive/.

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