Whenever possible, I try to build in most lessons on investing that I must share into examples using individual stocks. Sometimes, I’ll start with the lesson in mind, and then find a good individual stock to use as an example, and other times I start by looking at a specific stock, and then focus on some aspect of it I consider to be important, and which could also be applicable to other stocks that are in a similar position. A key concept that is often mentioned in the comments of many of my articles is what each investor’s return goals are (though seldom does it come in a formal manner). A person’s return goals are a crucial aspect that doesn’t get enough attention. In this article as well as sharing my preferred valuation procedure that I use for Home Depot (NYSE:HD) stock and the Home Depot stock, I’ll touch on the topic of return goals as well and how they can have a major impact on how we approach the valuation of a company like Home Depot. I’ve only written on Home Depot once before back in 2019, when I rated the stock a “Hold”. It has performed roughly the similar to the S&P 500 since then so that’s probably an precise assessment back then.
My valuation method is becoming a bit more precise since mid-2019, but at its heart, it’s still largely identical. The way I approach it is to try to identify, through a combination of P/E mean reversion, earnings yield, and earnings growth expectations and what kind of long-term CAGR we can anticipate from Home Depot stock if purchased at the current price and kept for 10 years. This is then used to calculate a rough CAGR estimate to compare the stock against my goals for return and determine at what cost I’d be willing to pay.
This article will cover three things. First, I will run through my normal valuation process to determine the value of Home Depot stock. After that, I’ll consider the various adjustments that I believe are appropriate to make for that estimate. And lastly, I discuss how investors’ return goals will color the time when Home Depot stock looks attractive as an investment. I will also include the analysis of dividends.
Let’s start with the basic analysis.
How Cyclical Is Home Depot’s Business?
Before I begin an analysis, I always review the company’s earnings patterns in order to determine if the company is appropriate for this sort of earnings analysis. When the earnings history 1) do not have a long enough time span,) are unpredictable in nature, or) appear to be too unpredictable, I either avoid analyzing the stock in any way or use a different type of analysis that is more appropriate for the particular stock.
In the past 20 year, Home Depot has grown its earnings per share every year except for the three years that were impacted by the severe financial crisis of 2007, 2008, and 2009. At that time, in the total of those three calendar years the growth in EPS for Home Depot decreased by a bit more than 40%. My general rule of thumb on whether to label a company to be a “deep cycle” one is its earnings are likely to drop by -50% or more during downtimes, and I do not consider Home Depot a “deep cyclical” stock. But, it has a moderate to deep earnings cyclicality historically. Moreover, since the 2020 recession was unusual in its scope and we haven’t had a “normal” recession since 2009, it’s crucial to be aware that should we experience a recession Home Depot’s growth in earnings is likely to be negative. The odds aren’t as severe as 2007-2009, but most analyses being done today (including the basic analysis I’ll start with in this article) will not incorporate this sort of earnings growth fall into their long-term profit growth estimates. But, in the event that we make that adjustment at some point during our analysis, it’s okay to utilize my regular “Full-Cycle Analysis” for this particular business, so that’s what I’ll do in this piece.
Market Sentiment Return Expectations
To estimate what sort of returns could be expected in the next 10 years, we should begin by looking at what kind of return we can expect in the next 10 years if the P/E multiple was to return to its mean from the previous cycle. Since we have had a recent recession (albeit an unusual one), I’m starting this cycle with fiscal year 2015 and will continue through 2023’s estimates.
Home Depot’s average P/E from 2015 to present has been about 22.35 (the blue line that is circled using gold appears on the FAST Graphs). If we take 2023’s forward earnings estimates of $16.55 (also marked in the gold), Home Depot has an estimated P/E of 17.71. If the 17.71 P/E Home Depot stock forecast were to revert to the average P/E of 22.35 over the course of the next 10 years and all other factors were held the same, the value of Home Depot would rise , which would produce a 10-Year CAGR of +2.34%. That’s the annual return that we could expect from sentiment mean reversion in the event that it lasts 10 years before reverting. If it takes less time to revert and return, the rate would be higher.
Business Earnings Expectations
We’ve previously looked at what would take place if the market’s sentiment changed back to its normal. It is completely dependent on what the general mood is, and is usually not linked, or only loosely connected, to the performance of the actual business. In this section we will take a look at how much money the business. The goal here is simple we want to know the amount of money we could make (expressed as CAGR percentage) over the course of 10 years if we purchased the company today at today’s price and kept all of the profits to us.
There are two primary aspects of this: one is the yield on earnings and the second one is the rate at which earnings could be expected to grow. Let’s look at the earnings yield (which is an inverted ratio of P/E, i.e the Earnings/Price metric). The current earnings yield is +5.64 percent. One way I like to think about this is, if I bought the company’s entire operation right now for $100, I would make $5.64 per year from my investment, assuming that earnings remain the same for the coming 10 years.
The next step is to estimate how much the company’s earnings will grow during this time. I do that by figuring out the rate at which earnings grew during the last cycle and then applying that figure to the subsequent 10 years. This is done by calculating the EPS growth rate since 2015, taking into account each year’s EPS growth or decline, and taking out any share buybacks in the time frame (because cutting down on shares can increase the EPS as there are fewer shares).
Home Depot has repurchased a large amount of its stock over the last 20 years (ironically with the exception of when the price of its stock falls significantly during recessions, such as in 2008 and 2020) and these buybacks have contributed to an EPS that has been steady and fairly high growth. In the last year in particular, they have purchased about 1/5th of the company. I will back the buybacks in my estimation of earnings growth. Once I’ve done that, I’ll have an estimate of earnings growth of +14.93% since 2015.
Then, I’ll add that increase rate to my current earnings in the future, looking 10 years ahead to arrive at an estimate of the 10-year CAGR. My way of thinking about this is: if I bought Home Depot’s whole business for $100 and it paid me back $5.64 plus +14.93 percent growth in the initial year, and that amount will grow at +14.93% per year over the next 10 years. I’d like to know much I could earn in total at the end of 10 years from my $100 investment, which I’m estimating to be approximately $230.96 (including the initial $100). If I plug this growth into a CAGR calculator, it translates to a +8.73 percent 10-year CAGR estimate for the expected company earnings return.
10-Year, Full-Cycle CAGR Estimate
Potential future returns can come from two different sources: market sentiment returns or the business earnings return. If we assume that market sentiment goes back to the mean of the previous cycle over this period of time for Home Depot, it will result in a +2.34% CAGR. If the earnings yield and growth are similar to last cycle, the company is expected to yield around +8.73 percent CAGR over the next 10 years. If we add both of them together, we’ll have an estimated 10-year, full-cycle CAGR of +11.07% , at the price of today.
My Buy/Sell/Hold range in this category of stocks is: above an expected CAGR of 12% is considered a Buy, below an expected CAGR of 4% is considered a Sell, and anything between the range of 4% to 12% is a Hold. This leaves Home Depot undervalued, and currently it is a “Hold” but is very close to my buying threshold of 12%, and if the price fell to about $277 this would mean it was close to the threshold for buying. However, I think my fundamental analysis is optimistic, for a variety of reasons which I’ll explain in the next section.
Additional Considerations
When a stock is close to my usual buy price I always like to test my assumptions some additional scrutiny. Usually, this means looking outwards and asking whether my assumptions are valid or not, while also considering any potential risks that may not be incorporated into those assumptions.
One of the first signs of concern to investors could be that the analysts who cover the stock expect 6 to 7 percent growth in earnings per share in the fiscal years 2023 and 2024, and 2025. It is also likely to include effects of stock buybacks. Therefore, if we take the buyback out analysts can believe that they will see 5% organic profit growth going forward. This is about 1/3rd of the growth rate of 2015, which was the figure I used in my initial assessment of this stock. I cannot stress enough that it’s very rare to see this kind of cautiousness on the part of analysts when the previous growth in earnings has been exceptionally robust. However, when we take close look at these numbers and apply the context of this, then I think the conservative estimates are logical.
From the fiscal year of 2015 until the year 2018 EPS declines were steady from 22% to 16% (even more if you remove buybacks). However, in the calendar year in 2018 (fiscal 2019) the company received corporate tax cuts that certainly helped Home Depot’s profit rise that year. Although EPS increased by 33% in that year, revenue was up 7.23%.
This 33 percent EPS growth year in fiscal year 2019 was probably an outlier in EPS growth for the year.
Then in fiscal 2021 and 2022, we saw huge government stimulus, as well as the exodus of city dwellers to suburbia and the countryside. This could result in two years of unusually strong EPS growth. In the years between had a 4% increase in EPS. Putting this all together I think that analysts’ estimates for the next 3 years of EPS growth are probably very accurate estimates.
If I used an estimated 7% growth rate in place of the +14.93% assumption for my fundamental analysis, I’d be able to calculate a 10-year CAGR of +8.13 percent, which is right at the middle of my fair value even if all other variables were kept constant, and much farther away from being a “buy” for me in my book. But slower growth in earnings is not the only danger associated with Home Depot stock.
The additional danger is the fact that my analysis didn’t take into consideration an “normal” recession. The profits of Home Depot fell by -40% from 2007-2009. It was a recession that was severe that impacted HD’s customers at the end of the line quite a bit, which means that earnings may not decline that much in the next recession. However, I would assume that there will be two years of decline and a cumulative earnings decline of -30% during an average recession (which will happen in the next 10 years). If the recession were to occur in the space of a few years, and we included it in our cumulative earnings growth estimate, the earnings growth rate CAGR for the cumulative earnings over a period of 10 years would fall to +2.58 percentage. If we apply this assumption for earnings growth and we calculate a 10-year CAGR expectation of +7.04%. It’s still close to fair value, but there could be knock-on effects of a rate of growth that is slows.
If we are really talking about an earnings growth rate of low-to-mid-single-digits, it’s probably not reasonable to ever expect the P/E to revert back to over 22. This is why I believe that we must forget about the mean reversion part of the estimation. Mean reversion is typically able to be a reliable indicator for stocks that have earnings increasing at the same rate as they did before. If we eliminate the +2.34 percentage mean reversion forecast, then we get an expected 10-year CAGR of +4.70% and is much closer to being an “Sell” rather than a “Buy”. With these assumptions, and also removing the mean reversion Home Depot stock would need to drop below $138 to be a share before it becomes a “buy” for me.
Dividend Payback Analysis
Because Home Depot has a pretty long track record of paying steady dividend and seems to have lots of dividend-paying investors interested in the company and I thought it would be a good idea to include a detailed analysis of the dividend here too. One of the benefits of the dividend analysis is that dividends are likely to continue to rise over the next decade regardless of whether the growth of earnings slows , as I believe it to. Additionally, based on the assumptions I make regarding earnings and recessions my usual analysis gives an extremely wide range of outcomes. A dividend analysis might provide a way to shift our perspective on which part of the range makes most sense.
Thoughts on Returns Thresholds
Okay, I’ve looked at Home Depot stock from a variety of different angles, and it looks like somewhere under $150 per share, which is about half of where it trades at, it could be a good price to buy. I’m sure many investors reading this article think Home Depot stock will never be that low. And to that I have a couple of points to make. The first is that my “buy prices” are not the traditional “price targets” you get from analysts. I am not predicting Home Depot stock will necessarily decline that much. What I’m saying is that if it falls this low, I’ll most likely buy the stock. I don’t have a jar of cash labeled “Home Depot Stock” and waiting to invest it into Home Depot that will go to waste if it does not reach the level I’m hoping for. Instead, I’ve got an accumulation of cash and I keep an eye on approximately 600 stocks daily to determine which ones hit my buy prices. Given the amount of cash I have right now If I can manage to get 30-40 percent to hit from the 600 over these two years, then I’ll be in very good shape.
It doesn’t mean that everyone needs to purchase at the same prices as I do, and that one buy price is just as good and another is not. This is where one’s goals for return and expectations are important. Assuming we don’t have an inflationary or depression, my objective is to attain overall portfolio returns in the range of 15 percent to 20% per year over the long term. It’s about 50% or more than the average long-term return from the S&P 500 index and about equal to or -25% lower than the long-term returns that are offered by Berkshire Hathaway. Because I’m seeking higher returns, I pretty practically have to purchase stocks when they’re cheap. Additionally, I’ll need to determine very profitable long-term investors early. or, I have to know when we are at the peak of the economic cycle or near the bottom. Also, I attempt to do all of these things, none of which are particularly easy for an average investor to accomplish.
However, not all investors are aiming for such high returns. Certain investors simply want market returns, and so they use indexes. Others are only concerned with the income generated from assets and not on the asset prices , so they are focused on income and dividends. Some investors are thrilled to point out that their dividends return an average of from 7% to 8% each year. I am not one of those investors. Firstof all, I don’t care about whether my gains come from capital gains or dividends or whether they are real or not. I’ll be taking the profits in any form I can obtain them in. In normal circumstances, I’d prefer 15 20 to 20% long-term annual returns. Many investors do not strive for such returns.
This results in a scenario if we think of the market as essentially an auction of future returns. The auctioneer starts off the bidding at an annual rate of 1% for each of the stocks, and the auctioneer, if no bidders raises the return to 2% and repeats the process until all the stocks on the market are sold each day. Even if every investor had perfect knowledge of what the future value of the stock would be, depending on each investor’s specific return they could be able buy a share on the same day but they might not if all the stocks get sold before the required return has been met. If there are many investors willing to take on lower return on their investments, then someone like me may not have the chance to purchase something that offers the highest future returns I’m seeking. However, we do not know what the future return will be for any specific company, and that’s when you combine it with economic and political conditions outside the U.S. along with the fact many investors limit themselves to certain kinds of stocks (like dividend-payers, or fast growth, or technology, or non-cyclical ) or U.S. stocks …), and the fact that many traders don’t think about the long-term return of their investments even if they do, this can mean that now and then I do get the chance to invest in stocks that have a high potential for return. But, I’m in the hands of other investors who would accept a lower future return than I can. That’s how it is.
My main point is that as long as we’re dealing with an extremely high-quality company that is likely to yield a profit over the medium or long term similar to what we have in the case of Home Depot, there isn’t necessarily an “wrong” cost to buy it. In the event that an investor would be happy with the 2.51 per cent dividend yield which will increase by 11% every year over the next ten years and is in line with their expectations, then more power to them should they decide to purchase the stock here. I’m just aiming for higher returns than this. So I’ll just wait.
Conclusion
There are many factors to consider. Home Depot stock’s performance over the next three years depends on whether we’re in one or the other recession, or not. I think the odds of a recession are very high and therefore, I believe my ideal scenario of the company’s stock would be that it will fall another -30% to -35% from here at some point over the next couple of years. If it falls more than -50% I’ll likely be buying. I don’t believe Home Depot is much more valued than the general market however, and should we avoid an economic recession, and the returns probably won’t be anything spectacular, it will likely be able to do just fine. Therefore, I’m giving the stock a “Hold” here even though I believe there are some risks that aren’t being priced in the stock, at least not yet, because stocks with similar characteristics aren’t much more expensive in comparison to Home Depot at the moment and it’s not easy to assess how severe or light the recession could be should it happen.
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