As often as I can, I strive to translate the most important lessons on investing that I must present into examples using individual stocks. Sometimes, I have the lessons in mind then I search for an individual stock to serve as an example, and other times I start by examining an individual stock and then hone in on a specific aspect I believe is crucial, which can also be applied to other stocks in the same situation. One important concept that usually comes up in the comments of my posts is the question of what each investor’s goals for return are (though seldom does it come out in the open). The return goals of an investor are a significant aspect that isn’t often given the proper attention. In this article, along with sharing my valuation methodology that I use for Home Depot (NYSE:HD) stock and the Home Depot stock, I’ll talk about return goals as well and how they could play a major role in how you approach the valuation of a company like Home Depot. I’ve only written about Home Depot once before back in the year 2019, when I rated the stock a “Hold”. It has performed roughly the identical to S&P 500 since then so that’s probably an accurate assessment when I wrote it.
My process of valuation has become more refined since mid-2019 however, at the core it’s identical. The way I approach it is determine, using an amalgamation of P/E the reversion of earnings, its yield and expectations for earnings growth and what kind of long-term CAGR we might expect of Home Depot stock if purchased at current prices and maintained over a period of 10 years. And then I use that rough CAGR estimate to evaluate the stock against my expectations for return in order to determine at what price I’d be willing to purchase it.
This article will accomplish three things. First, I will run through my usual valuation procedure for Home Depot stock. Next, I’ll look at some adjustments I think would be reasonable to take into consideration in that estimation. And lastly, I discuss how investors’ returns goals will affect the price the way that Home Depot stock looks attractive as an investment. I’ll also provide an analysis of dividends.
Let’s begin with the fundamental analysis.
How Cyclical Is Home Depot’s Business?
Before I begin an analysis, I always review the company’s earnings trends to ensure that the business is appropriate for this kind of analysis. When the earnings history 1) don’t have a long enough track record,) are fluctuating in nature or) are too cyclical, then I don’t bother analyzing the stock completely or employ a different method of analysis that is more suitable for the stock.
Over the past twenty decades, Home Depot has grown its earnings per share in every year except for the three years of the great financial crisis in 2007, 2008, and 2009. In those three calendar years Home Depot’s earnings growth decreased by a bit more than -40%. My general rule of thumb for when to consider a stock to be to be a “deep cycle” stocks is earnings typically fall by at least -50% during downturns, which is why I don’t think that Home Depot a “deep cyclical” stock. But, it has a moderate to deep earnings cyclicality in the past, and considering that the recession in 2020 was not typical in its nature, and we haven’t had a “normal” economic recession after 2009, it’s crucial to understand that if there is a recession, Home Depot’s growth in earnings is likely to be negative. It probably won’t be the same as 2007-2009 however the majority of analysis being conducted today (including the basic analysis I’ll begin by presenting in the article) probably won’t build in this sort of earnings growth drop into their long-term earnings growth estimates. But, it’s fine to do that at some point in our analysis, it’s perfectly acceptable to employ my usual “Full-Cycle Analysis” for this particular business, so that’s what I’ll be doing in this article.
Market Sentiment , Return Expectations for the Future
To determine the kinds of returns could be expected over the next 10 years, let’s start by looking at what kind of return we could anticipate 10 years from now , if the P/E multiplier was to return to its normal value from the prior economic cycle. As we’ve seen recently experienced a recession (albeit an unusual one), I’m starting this cycle in fiscal year 2015 and will continue through 2023’s forecasts.
Home Depot’s P/E average from 2015 until the moment is 22.35 (the blue bar that is circled by gold is shown on FAST Graphs). Using 2023’s forward earnings estimates of $16.55 (also indicated with the gold), Home Depot has an underlying P/E of 17.71. If that 17.71 P/E were to return to the average of 22.35 over the course of over the course of 10 years and all other factors were held the same, the value of Home Depot would rise , which would yield a 10-year CAGR of +2.34 percent. This is the annual yield we can expect from sentiment mean reversion, assuming it takes 10 years to revert. If it is quicker to change and return, the rate would be higher.
Business Earnings Expectations
We previously examined what would take place if the market’s sentiment changed back to its normal. It is completely determined by the mood of the market, and is quite often disconnected from, or even less connected, to the performance of the actual business. In this article we will take a look at the actual earnings of the business. The goal here is simple The goal is to determine what amount of money we’d make (expressed in terms of CAGR percentage) over the course of 10 years if we bought the business at today’s prices and held all the earnings for us.
There are two major elements of this: one is the yield on earnings and the second one is the rate at which the earnings could be expected to increase. Let’s look at the earnings yield (which is an inverted ratio of P/E, i.e that’s the Earnings/Price relationship). The current yield for earnings is about +5.64 percent. The way I prefer to think about this is, If I were to buy the company’s whole operation today at $100, I’d be earning $5.64 annually on my investment if the earnings were unchanged for the coming 10 years.
The next step is to estimate the growth in earnings of the company during this time. This is done by figuring out the rate at which earnings increased in the last cycle, and applying that number to the following 10 years. This requires calculating the EPS growth rate since 2015, taking into account the EPS growth rate for each year or decline, and then taking out any share buybacks which occurred during the period (because reducing shares will increase the EPS because of fewer shares).
Home Depot has repurchased a number of shares over the past 20 years (ironically in the event that the stock price falls deeply during recessions, as in 2008 and 2020) and these buybacks are a major reason for the steady and relatively high EPS growth. In the year 2015 alone, they have purchased around 1/5th the company. I will back these buybacks up when estimating growth in earnings. After doing that I get an estimate of earnings growth of +14.93 percent since 2015.
Next, I’ll apply that growth rate to earnings currently and then look forward to 10 years to arrive at an estimated CAGR for the 10 years to come. The way I look at this is that if I bought Home Depot’s whole business for $100 and it paid me in $5.64 plus +14.93 percent growth in the first year, and the amount would increase by +14.93% per year for the next 10 years. I’d like to know the amount of money I’d earn at the end of 10 years from the $100 investment that I estimate to be around $230.96 (including the initial $100). When I plug that number into an CAGR calculator, that amounts to a +8.73 percent 10 year CAGR estimate of expected company earnings return.
10-Year, Full-Cycle CAGR Estimate
Future future returns may come from two different sources either from market sentiment returns or the business earnings return. If we assume that the sentiment of the market returns to its mean from the previous cycle over the next 10 years for Home Depot, it will generate a +2.34 percent CAGR. If the growth and yield on earnings are similar to those of the previous cycle, then the company should produce somewhere around a +8.73% 10-year CAGR. If we add the two together, we get an expected 10-year, full-cycle CAGR of +11.07% at today’s price.
My range of Buy/Sell/Hold for this type of stocks is that anything above the 12% expected CAGR, it’s considered a Buy, below an expected CAGR of 4% is considered a Sell, and anything in between the 4% and 12% mark is a Hold. This leaves Home Depot undervalued, and currently an “Hold” however, it is close to my buying threshold of 12%, and should the price fall to $277, it would cross that threshold for buying. But, I believe that my base analysis here is extremely optimistic due to several reasons that I’ll explain in the next section.
Additional Questions
Every time a stock has a chance to get close to my normal purchase price, I try to examine my assumptions with an additional examination. Usually, this means looking outwards and asking whether my assumptions are fair or not, and considering the possibility of any obvious risks that could not be factored into the assumptions.
One of the first signs of concern in the eyes of investors would be the news that analyst covering the stock are expecting 6-7% EPS growth in the fiscal years 2023 and 2024, and 2025. This is likely to include the effects of stock buybacks. So, really, if you take out the buyback, analysts probably anticipate 5% organic earnings growth going forward. This would be about 1/3rd the growth rate since 2015, which is what I used in my initial review of this stock. It’s hard to emphasize enough that it’s very rare to witness this type of conservativeness from analysts, especially when the prior growth in earnings has been extremely strong. However, when we take more closely at the data and put it into some context, I believe this kind of conservative estimate is logical.
First, from the fiscal year 2015 through 2018 EPS declines were steady from 22 percent to 16% (even more if you remove the buybacks). But in the calendar year 2018 (fiscal 2019), we had corporate tax cuts that certainly helped Home Depot’s profit rise that year. While EPS increased by 33% in that year, revenue increased by 7.23%.
So, this 33 percent EPS growth in fiscal 2019 could be an anomaly in the EPS growth rate for one year.
In the years 2021 and 2022, there was a massive stimulus from the government and an exodus out of cities and into suburbs and the countryside. This could result in two more years of unusually strong EPS growth. In the time between had a 4% increase in EPS. In the end I think that analysts’ projections for the coming three years of EPS growth are likely very reasonable estimates.
On the Home Depot stock forecast, if I was to apply the 7% growth rate as opposed to the +14.93 percent estimate for my fundamental analysis, I would get a CAGR for 10 years of +8.13 percent that is close to the middle of fair value for me, even if all other variables were kept at the same level, and is further away from being a “buy” within my opinion. However, slower earnings growth is not the only danger associated with Home Depot stock.
Another danger is that my analysis of the situation didn’t take into consideration an “normal” recession. The earnings of Home Depot dropped by -40% from 2007-2009. That was a deep recession that affected HD’s final customers significantly, so earnings may not decline that much in the next recession, however I believe it’s safe to assume two years of decline , with a cumulative earnings decline by -30% during an average recession (which will happen in this decade). If a recession were to occur within a couple of years from now and we were to include it in our estimate of cumulative earnings growth that would mean the earnings growth rate CAGR for the cumulative earnings over the next 10 years would be +2.58 percentage. And if we use the assumption of earnings growth and we calculate a 10-year CAGR expectation of +7.04%. It’s still close to fair value, but there are likely knock-on consequences of a growth rate which is slow.
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 think we need to not be concerned about the mean-reversion part of the estimation. Mean reversion can typically only be used when earnings are growing at the same pace that they have before. If we take out the +2.34 percentage mean reversion forecast and we are left with an estimated 10-year CAGR of +4.70%, which is much closer to being more of a “Sell” than one that is a “Buy”. With these assumptions, and also removing the mean reversion, Home Depot stock would need to drop to around $138 per share before it would become an “buy” for me.
Dividend Payback Analysis
Because Home Depot has a pretty long tradition of paying a steady dividend and seems to have plenty of dividend investors that are interested in the stock, I thought I would include a dividend analysis in this article too. One of the benefits of a 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 yields an array of results. A dividend analysis may provide a way to shift our perception of which point of that spectrum makes the most sense.
Thoughts on Returns Thresholds
Alright, I’ve examined Home Depot stock from a range of angles and it seems as if it’s somewhere around $150 per share, or around half the price it is trading at the moment, it will be just low enough for me to invest in. I’m sure many investors who read this article believe that Home Depot stock will never reach that level. To that I’ve got a couple of responses. First, I believe that my “buy prices” are not typical “price targets” that analysts offer. I’m not making any predictions that Home Depot stock will necessarily be that low. What I am saying is if it does fall that low, I’ll probably purchase the stock. I don’t own a jar of money marked “Home Depot Stock” and waiting to invest it into Home Depot that will go in vain if the price doesn’t reach the value I’m seeking. Instead, I’ve got an accumulation of cash and I keep an eye on about 600 stocks every day to see whether any of them match my purchase prices. Given the amount of cash I’m sitting on If I am able to find 30-40% of the 600 in these two years then I’ll be in very good health.
However, that doesn’t mean everybody has to buy at the same prices as I do, and the fact that one price may be just as good and another is not. This is where one’s goals for return and expectations become relevant. Assuming we don’t have an inflationary or depression, my objective is to achieve overall portfolio returns in the range of 15 to 20 percent per year , on average, over the long term. That’s roughly 50% to 100% higher than the average long-term return of the S&P 500 index and about equal to or -25% smaller than the returns over the long term that are offered by Berkshire Hathaway. Because I’m seeking higher returns, I pretty must mathematically buy stocks at times when they’re extremely affordable. Or, I need to find very reliable long-term investors early. Or, I need to be aware of when we are at the top of an economic cycle or near its bottom. And I try to do all of these things, but none of them are particularly easy for an common investor.
It is important to note that there are many investors who aim to earn such high returns. Certain investors simply want market returns, and so they index. Others are only concerned with the income produced from the assets, and not the prices themselves, so they focus only on income and dividends. There are investors who are thrilled to point out that their dividend returns average from 7% to 8% per year. I’m not one these investors. In the first place, I don’t mind whether the returns I earn are from capital gains or dividends or whether they’re realized or not. I’ll be taking the profits in any form I can receive them. In normal circumstances, I’d prefer 15 20 to 20% annual long-term returns. Many investors do not strive for such returns.
This can lead to a situation it is possible to think of the market as essentially an auction for future returns. The auctioneer starts off the bidding at the rate of 1% per year for each of the stocks, and after that, if there’s no buyers, the return increases to 2% and so on until all of the stocks that are on the market are sold every day. Even if each investor had a complete understanding of what their future returns would be, contingent on each investor’s specific return they might be able to buy a share on some day or they might not be able to if all the stocks get removed before their return is reached. If there are a lot of investors who are willing to take a risk on low future returns, then an investor like me might not get the chance to buy something with the high future return I’m after. We don’t know how much future returns will be for any particular company, and that’s when you combine it with external economic conditions as well as the reality that a lot of investors restrict themselves to specific kinds of stocks (like dividend-payers, fast growth, or tech or non-cyclical, or only U.S. shares …), and 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 opportunity to buy stocks with a high chance of returning. Nevertheless, I am always dependent on other investors who are more willing to take a lower return in the future than I are. That’s how it is.
The point I am trying to make is that, assuming that we own an outstanding business likely to generate a future return over the medium or long-term like we did with Home Depot, there isn’t necessarily an “wrong” price to purchase it at. When an investor’s pleased with a 2.51 percent dividend yield that increases at 11% each year over the next decade and meets their objectives, then more than they deserve if they want to buy the stock. I’m simply looking for better yields over that. So I’ll just wait.
Conclusion
Much about Home Depot stock’s performance over the next three years will depend on whether we’re in an economic bear market or a recession. I think the odds of a recession are high, and so I think my best case scenario of the company’s stock would be that it could fall further -30%-35 percentage from here at some point over the next couple of years. If it falls more than -50% from here, I’ll probably be a buyer. I don’t think Home Depot is much more overvalued than the market overall However, even if we do not experience an economic recession, and the returns won’t be that great, the stock will likely do okay. For that reason, I’m giving the stock as a “Hold” here even though I think there are risks which aren’t factored into the stock yet, because stocks with similar profiles aren’t necessarily more expensive in comparison to Home Depot at the moment and it’s difficult to determine the extent of the recession could be should it occur.
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