If I can, I try to incorporate the majority of lessons in investing I need to present into examples using individual stocks. Sometimes, I begin with the concept in mind and then look for a suitable individual stock to use as an example. sometimes I begin by looking at a specific stock, and then focus on a specific aspect I believe is crucial, which could also be applicable to other stocks that are in the same situation. A key concept that is often mentioned frequently in the comments sections of my posts is the question of what the goals of each investor are (though seldom does it come in a formal manner). Return goals are an important aspect that isn’t given enough consideration. In this article I’ll also share my usual valuation method of Home Depot (NYSE:HD) stock I’ll also discuss return goals and how they can be a significant factor in how we 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 gave the stock with a “Hold”. It’s performed about the similar to the S&P 500 since then so it was likely an precise evaluation in the moment.
My method of valuing has become more precise since mid-2019, however, at the core it’s basically similar. The way I approach it is determine, using the combination of P/E mean the reversion of earnings, its yield and expectations for earnings growth and what kind of long-term CAGR we can be expecting to see from Home Depot stock if purchased at current prices and kept over a period of 10 years. Then, I utilize that rough CAGR estimate to evaluate the stock against my goals for return to determine the price at which I’d be willing to purchase it.
This article will accomplish three things. The first is to run through my usual valuation process to determine the value of Home Depot stock. After that, I’ll consider certain adjustments I believe are appropriate to make in this estimate. Then, I discuss how investors’ returns goals will affect the price the time when Home Depot stock looks attractive as an investment. I’ll also provide an analysis of dividends as well.
Let’s begin with the fundamental analysis.
How Cyclical is Home Depot’s business?
Before beginning an analysis, I examine the company’s long-term earnings trends to determine if the company is suitable to conduct this type of analysis. When the earnings history 1) do not have a long enough time span,) are unpredictable in nature, or) tend to be too seasonal, then I choose to either not analyze the stock at all or employ a different method of analysis that is more suitable for the company.
In the last twenty decades, Home Depot has grown its earnings per share in every year , with the exception of three years that were impacted by the severe financial crisis of 2007 2008, and 2009. In the three years that spanned the growth in EPS for Home Depot decreased by a bit more than 40%. My general rule of thumb for when to classify a stock as to be a “deep cycle” company is the fact that its earnings typically fall by at least -50% during downturns, which is why I don’t think of Home Depot a “deep cyclical” stock. However, it has a moderate to deep earnings cyclicality historically. Moreover, since the recession of 2020 was unique in its nature, and we haven’t experienced an “normal” recession in the last few years, it’s crucial to recognize that if there is a recession, the growth of Home Depot’s earnings will likely be negative. The odds aren’t as severe as 2007-2009, however, the majority of analyses that are being conducted in the present (including the analysis I’ll begin by presenting in the article) likely won’t factor in the kind of earnings decrease into their long-term earnings growth projections. But, in the event that we adjust that number at some point during our analysis, it’s okay to apply my standard “Full-Cycle Analysis” for this particular business and that’s exactly the approach I’ll take in this piece.
Market Sentiment and Return Expectations
To determine the kind of returns we can expect in the next 10 years, let’s start by looking at what kind of return we can expect in the next 10 years if the P/E ratio was to return to its normal value from the previous cycle. Because we’ve experienced an economic recession in recent times (albeit not a typical one) I’m beginning this cycle in the fiscal year 2015 and will continue through 2023’s Home Depot stock forecast.
The average P/E of Home Depot from 2015 until the current time has been around 22.35 (the blue line is circled with gold in the FAST graphs). Based on the forward estimates for 2023’s earnings of $16.55 (also highlighted with the gold), Home Depot has an underlying P/E of 17.71. If the 17.71 P/E were to change to the average P/E of 22.35 over the course of over the course of 10 years, and all other factors were held the same, the price of Home Depot will rise, and it will yield a 10-year CAGR of +2.34 percent. This is the annual return that we could expect from sentiment mean reversion, assuming it is a period of 10 years before it reverses. If it takes less time to reverse and return, the rate would be greater.
Business Earnings Expectations
We have previously discussed what might occur if market sentiment reversed to its mean. It is completely dependent on how the markets behave, and is often not connected or at best, not connected, to the actual performance of the business. In this article we will look at the actual profits of the company. The purpose here is straightforward we want to know the amount of money we could make (expressed as CAGR percent) over the course of ten years if we purchased the company at the current price and kept all the profits to us.
There are two major elements of this: one is the yield on earnings and the second one is how fast the earnings are expected to increase. Let’s begin with the earnings yield (which is an inverted P/E ratio, hence it is the Earnings/Price ratio). The current yield for earnings is around +5.64 percent. My preferred way to consider this is: If I were to buy the company’s entire business today for $100, I’d be earning $5.64 annually on my investment, assuming that earnings remain similar over the following 10 years.
The next step is to determine the growth in earnings of the company during the time. This is done by figuring out the rate at which earnings increased during the previous cycle, and then applying that rate to the following 10 years. This is done by calculating the EPS growth rate from 2015 and taking into consideration the EPS growth rate for each year or decrease, and securing any share buybacks that took place during that time (because cutting down on shares can increase the EPS because of fewer shares).
Home Depot has repurchased a large amount of its stock over the last 20 years (ironically not so much when the price of its stock falls significantly during recessions, such as in the years 2008 and 2020) and these buybacks have led to an EPS that has been steady and fairly high growth. In the year 2015 all of them, they’ve purchased about 1/5th of the company. I’ll back these buybacks when estimating the growth in earnings. When I do that, I have an estimate of earnings growth of +14.93 percent since 2015.
Then, I’ll apply the growth rate to the current earnings and then look forward to 10 years to arrive at an estimate of the 10-year CAGR. My way of thinking about this is that If I purchased the entire business of Home Depot for $100 and it paid me the amount of $5.64 plus +14.93 percent growth in the first year, and the amount will grow at +14.93 percent per year for the next 10 years. I’d like to know the amount of money I’d have in total at the end of 10 years from the $100 investment that I estimate to be around $230.96 (including the initial $100). If I plug that figure into an CAGR calculator, it translates to an +8.73 percent 10-year CAGR estimation of the anticipated profits of a business.
10-Year, Full-Cycle CAGR Estimate
Future potential returns could be derived from two sources such as market sentiment or business earnings. If we believe that sentiment in the market returns to its mean from the previous cycle over 10-year intervals for Home Depot, it will result in an +2.34 percent CAGR. If the growth rate and earnings are similar to those of the previous cycle, the company will achieve a +8.73 percent 10-year CAGR. If we add both of them together, we will get an estimated 10-year, full-cycle CAGR of +11.07 percent at the current price.
My Buy/Sell/Hold range in this category of stocks is: Above 12 percent CAGR is an investment, below the 4% CAGR expected is considered a Sell, and anything in between the 4% and 12% mark is an investment. This makes Home Depot undervalued, and currently an “Hold” however, it is close to my threshold for buying of 12%. And should the price fall to $277 the stock would be close to that threshold for buying. But, I believe that my fundamental analysis is optimistic due to a number of reasons that I’ll discuss in the following section.
Additional Requirements
When a stock is close to my usual purchase price, I like to examine my assumptions with more scrutiny. Usually, this means looking outwards and asking the question of whether my basic assumptions are valid or not, as well as evaluating the possibility of any obvious risks that may not be incorporated into the assumptions.
The first sign of caution to investors could be that the analysts covering the stock are predicting an increase of 6-7% in EPS for the fiscal years 2023, 2024, and 2025. This is likely to include the effect of stock buybacks. If we remove the buyback analysts should anticipate 5% organic earnings growth in the coming years. This is about 1/3rd of the growth rate from 2015, which is the number I used for my initial assessment on the company’s stock. I cannot stress enough how rare it is to observe this kind of cautiousness on the part of analysts, especially when the prior growth in earnings has been extremely robust. But, if we look an in-depth look and apply certain contexts, I believe these estimates are reasonable.
In the first instance, from the fiscal year of 2015 until the year 2018, EPS growth steadily declined from 22 percent to 16 percent (even more if we eliminated the buybacks). However, in calendar year 2018, (fiscal 2019) we saw corporate tax cuts that certainly helped Home Depot’s profit increase that year. Although EPS increased by 33% in the year before, revenue increased by 7.23 percent.
This 33 percent EPS growth year in fiscal 2019 is likely an outlier in EPS growth for the year.
In fiscal 2021 and 2022, we saw massive stimulus from the government and the exodus of city dwellers and into suburbs and the countryside. This likely led to two years of unusually large EPS growth, whereas the years between witnessed a 4% increase in EPS. When you look at it all in context I believe that analysts’ forecasts for the coming 3 years of EPS growth are probably very accurate estimates.
If I used an earnings growth of 7% rate assumption rather than the +14.93 percent assumption I used in my initial analysis, I’d get an annual CAGR of +8.13 percent that is close to the middle of fair value to me, in the event that everything else were held the same, but is far away from being an “buy” within my opinion. But slower growth in earnings isn’t the only risk for the stock. Home Depot stock.
Another risk is that my analysis of the situation did not consider the possibility of a “normal” recession. The earnings of Home Depot dropped by 40% from 2007 to 2009. This was a severe recession that impacted HD’s customers at the end of the line significantly, so earnings may not be that much lower during the next recession, however I believe it’s safe to suppose two years of decline , with an overall decline of -30% in the average recession (which will surely occur in the course of 10 years). If the recession were to occur within a couple of years, and we include it in our estimate of cumulative earnings growth then the rate of growth in earnings CAGR for the cumulative earnings over a period of 10 years would drop to +2.58 percent. If we take the assumption of earnings growth and we calculate a 10-year CAGR estimate of +7.04 percent. It’s still close to fair value, however 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 we should ignore the mean reversion part of the estimation. Mean reversion can typically only be used for companies whose earnings are increasing at the same rate like they did previously. If we take out the +2.34 percent mean reversion expectations and we are left with an estimated 10-year CAGR of +4.70 percent that is closer to being an “Sell” rather than an “Buy”. Based on these assumptions, and taking out the mean reversion, Home Depot stock would need to drop to around $138 before it could be considered an “buy” for me.
Dividend Payback Analysis
Since Home Depot has a pretty long record of paying a regular dividend and seems to have a lot of dividend investors who are interested in the stock so I thought I’d include a dividend analysis in this article too. One benefit of an analysis of dividends is that the dividends are expected to continue rising in the coming years regardless of whether earnings growth slows down as I anticipate it to. Additionally, based on the I believe regarding recessions and earnings, my usual analysis yields an extremely wide range of outcomes. A dividend analysis may help us to adjust our perspective on which part of the spectrum makes the most sense.
Thoughts on Returns Thresholds
Okay, I’ve looked at Home Depot stock from a number of angles, and it appears as if it’s somewhere around 150 cents per share which is about 50% of the price it trades at the moment, it will be just low enough for me to consider buying. I’m sure that many investors who read this article believe that Home Depot stock will never drop that low. To that I have two points of view. First, the “buy prices” aren’t the typical “price targets” that analysts offer. I’m not saying that Home Depot stock will necessarily drop that low. What I’m saying is that if it falls to that level, I’ll likely purchase the stock. I don’t have a pot of cash marked “Home Depot Stock” that I am waiting to invest into Home Depot that will go to waste if it does not reach the level I’m hoping for. Instead, I’ve got an account with cash and I keep an eye on around 600 stocks each day to see whether any of them meet my purchase prices. Given the amount of money I’m currently holding and if I can find 30-40 percent of the 600 in 2 years, I’ll be in good condition.
This doesn’t mean that everyone has to pay the same prices as I do, and that one price for a purchase is correct and the other is not. This is where the return objectives and expectations play a role. If we do not experience an inflationary or depression, my aim is to get overall portfolio returns that range from 15 percent to 20% annually over the long run. This is roughly 50 to 100% higher than the average long-term return from the S&P 500 index and about 25% or more lower than the long-term return from Berkshire Hathaway. Since I’m looking for higher returns, I pretty practically have to purchase stocks at times when they’re extremely inexpensive. Also, I must find very reliable long-term winners earlier. Also, I must be aware of when we are at the peak of the economic cycle or close to the bottom. Also, I attempt to do each of those things. but none of them are easy for the average investor to accomplish.
It is important to note that not all investors are aiming at such returns. Certain investors simply want market returnsand that’s why they use indexes. Others are only concerned with the earnings generated by assets, not the prices , and so they concentrate on only dividends and income. Some investors are delighted to announce that their dividend yields average between 7% and 8% annually. I’m not one of the investors. Firstof all, I don’t care whether my earnings come from capital gains or dividends or if they’re real or not. I’ll take my returns in any form I can obtain them in. However, under normal circumstances, I would like 15 percent to 20% annual long-term returns. The majority of investors don’t aim to earn that much.
This leads to a situation it is possible to think of the market as an auction for future returns. The auctioneer begins by bidding at an annual rate of 1% for each stock, when there aren’t any bidders , they raise the amount to 2%, and repeats the process until all the stocks on the market are sold every day. Even if every investor knew exactly the expected future return be, based on each investor’s return requirement, they may be able to purchase a stock at the same day but they may not, if all stocks are sold before the required return is achieved. If there are a lot of investors who are willing to take a risk on low future returns, then a person like me may not have the chance to purchase something that has the future returns I’m hoping for. We don’t know what the future returns are likely to be for any particular stock, and this is combined with the external economic environment as well as the reality that a lot of investors are restricted to certain types of stocks (like dividend-paying stocks, or rapid growth, or tech or non-cyclical, or just U.S. stock …), and that a lot of traders don’t focus on long-term returns in any way, it which means that every once in a while, I have the chance to purchase stocks that have a high potential for return. However, I’m always in the hands of other investors who are more willing to take a lower return in the future than I are. This is just how it is.
The point I am trying to make is that, assuming that we own an excellent business that is likely to generate a future yield in the long or medium-term like we did in the case of Home Depot, there isn’t necessarily an “wrong” price to purchase it at. When an investor’s content with an 2.51 percent dividend yield that increases at 11% each year over the next 10 years and is in line with their expectations, then more than they deserve should they decide to purchase the stock here. I’m only looking for higher yields over the one that. Therefore, I’ll wait.
Conclusion
There are many factors to consider. Home Depot stock’s performance over the next three years is contingent on whether we are in an economic bear market or a recession, or not. I believe the chances of a recession are very high and therefore, I believe my ideal scenario of the company’s stock would be that it will fall further -30%-35 percent from now in the next couple of years. If it drops more than -50% from here I’m likely to be an investor. I don’t believe Home Depot is much more overvalued than the market overall however, and should we avoid recession, even though the return won’t be that great, the stock will probably do well. This is why I’m giving the stock with a “Hold” in this case, even though I believe there are some risks that aren’t being priced into the stock yet since stocks with similar characteristics aren’t much less expensive that Home Depot at the moment and it’s difficult to determine the severity or how mild the recession could be in the event of one.