Disclaimer: This is for entertainment and educational purposes only. This is not investment advice. I am not an investment advisor, nor have I considered your personal situation as your fiduciary. In other words, any investment you make (or don't make) is completely your responsibility.
Home Depot - Ticker: HD
Today someone in the facebook group (Shawn) was looking into Home Depot as a potential investment. I thought it would be fun to do a Quick and Dirty valuation of the business, to see where we are in terms of Value. He’s looking to invest long term (15+ years) which is always a good start in my books. Let’s dive in…
What we need to ask ourselves
Part 1: Am I capable of understanding this business? (Meaning)
Part 2: Does this business have excellent Long-term Economics? (Moat)
Part 3: Is the Management team honest and disciplined capital allocators?
Part 4: Is the stock seriously undervalued? (Margin of Safety)
(Google Finance, 2017)
As you can see above, Home Depot is BIG. They sport a market cap of 181.24 Billion (3x the size of Lowe’s). They currently have a PE ratio of 22.77 with an estimated PE ratio of 18.59 next year. They currently pay out a decent dividend of 2.34%.
Part 1: Meaning
I think this is very similar to the valuation I did previously on Lowe’s. If you own a house, you likely will know the business well. But let’s take an excerpt from Yahoo Finance for the full description:
The Home Depot, Inc. operates as a home improvement retailer. It operates The Home Depot stores that sell various building materials, home improvement products, and lawn and garden products, as well as provide installation, home maintenance, and professional service programs to do-it-yourself, do-it-for-me (DIFM), and professional customers. The company offers installation programs that include flooring, cabinets, countertops, water heaters, and sheds; and professional installation in various categories sold through its in-home sales programs, such as roofing, siding, windows, cabinet refacing, furnaces, and central air systems, as well as acts as a contractor to provide installation services to its DIFM customers through third-party installers. It primarily serves homeowners; and professional renovators/remodelers, general contractors, handymen, property managers, building service contractors, and specialty tradesmen, such as installers. The company also sells its products through online. It operates through approximately 2,278 stores, including 1,977 in the United States, including the Commonwealth of Puerto Rico, and the territories of the U.S. Virgin Islands and Guam; 182 in Canada; and 119 in Mexico. The Home Depot, Inc. was founded in 1978 and is based in Atlanta, Georgia.
Now you simply ask yourself “Am I going to be able to understand this business?”. If you answer ‘Yes’ you can move onto the next step. If you answer ‘No’ stop right here. For me this is an easy ‘Yes’. I literally was in there store yesterday looking at upright freezer (Ours died), and I understand what they do.
Part 2: Moat
This is where we ask ourselves if Home Depot has any durable competitive advantage that protects it from being destroyed.
Currently the two Moats I can see for Home Depot are:
1. Brand Moat: in other words people recognize and trust them and therefore buy their products.
2. Switching Moat: They are one of the two largest home improvement stores around and therefore will naturally have traffic driven to them for certain items.
I think Amazon is starting to take some of their business, but I don’t think it will completely erode its profits. I personally want to go and look at home improvement products before I buy them, and I don’t think I’m alone in this. So, for now I think Home Depot will be around for a good long while.
Part 3: Management
This is one of the most difficult and subjective components with investing. And yet, we still want to identify certain qualities that can potentially make for a ‘Next Level CEO’.
Here’s what we’re looking for: (from Jim Collins excellent book Good to Great).
As you can see, we ideally want to see a ‘Level 5’ leader at the helm of the businesses we invest in. They give the business the best opportunity of taking themselves to that ‘Next Level’ by properly leading and innovating from within.
Home Depot Management
Mr. Craig A. Menear Ceo and President since 2014.
This took a little digging, But it turns out Mr Menear has worked his way up the company after starting with Home Depot back in 1997. This is what I like to see. Someone with the skills and competency to move up on the ranks and take over as CEO.
Skills and qualifications: With more than three decades of experience in the retail and hardware home improvement industry, Mr. Menear brings to our Board extensive retail experience and knowledge of our business, including leadership experience in retail operations, merchandising, supply chain, vendor management and organizational development.
The next question we should ask ourselves is: Do the employees like him?
Let’s find out…
Looking through the glass door
Searching your business through the website called ‘Glassdoor’ is always a good idea before you make an investment. The culture of the business can have a large effect over time to the success of the company
There you have it, Craig menear has an 80% approval rating from his employees. That’s a pretty good number. It looks like Mr. Menear may be a ‘Next Level’ CEO after all. Now let’s look at his compensation.
CEO Compensation
The next thing we should always look at is how the CEO is compensated for their work. We have to ask ourselves ‘Do we think this CEO is being paid fairly?’ and ‘Is this CEO’s vision and motivation aligned with that of the shareholders?’.
In other words, is the CEO looking to boost Earnings for the short term to get some sort of bonus, or is the CEO looking much further into the future, assuring long-term appreciation of the business? This is not an easy question to ask, but we can get hints by looking at how they are compensated. You can garner some insight from how the CEO talks to the investors during the 10Q releases as well.
Since this is a ‘Quick and Dirty’ valuation, I won’t dig in too deep into the numbers. That being said, based on the bonus and stock awards, Mr. Menear may be getting compensated in a way that long-term investors aren’t looking for.
He’s currently making more than APPL’s CEO Tim cook as a reference point.
My quick look at the current CEO tells me that Craig Menear may in fact be a ‘Next Level’ CEO and one that I’d be happy to have running the business I’m investing in. I’d have to dig deeper into his bonuses and if the compensation is short term earnings target based.
Part 4: Margin of Safety
Here we are at the most exciting components of our analysis; The Valuation! As you’ve learned, we can’t pay (and don’t want to pay) an infinite price to own a business, even if it’s great. What we want to do as Next Level Investors, is own great businesses at great prices. That way, even if our valuation is off (Which it likely will be) we have a large Margin of Safety built into our price, protecting our downside risk, while simultaneously increasing our upside potential. Win-Win right?!
I can’t stress how important this step is. As long as we have a healthy MOS built into our buy price, we’ll likely do extremely well over the long term. The hard part is waiting for the business to hit our MOS price, but that’s exactly where Charlie Munger says the money is truly made…
“The Big money is not made in the buying and selling… But in the Waiting”
-Charlie Munger
Let’s first look at what growth rate has to be priced into today's stock price for Home Depot to justify it’s somewhat high PE ratio. We do this with something called a reverse engineered Discount Cash Flow (which basically looks at the current cash flow and growth and looks at what percent growth will be needed to justify todays price).
Reverse Engineered DCF
To keep things as simple as possible, we’ll use the Gurufocus calculator.
Here’s the current growth rate that is priced into Home Depot if we set our minimum return to 15%.
If you look to the right side of the calculator you will see the last 10 year, 5 year and 1 year growth numbers. Home Depot has had excellent growth numbers in the past, including a free cash flow growth rate of 15%. I like that quite a bit. What I don’t like is their current valuation. In order to justify their current share price, they will need to grow at 20.62% per year. Looking at their past growth numbers, this just doesn’t seem feasible to me.
Let’s find a fair value to Home depot and see if we’re closer on that end.
Home Depot’s Current Value and Margin Of Safety Price
We’ll use the Gurufocus calculator once again to find our fair value price for Home depot as well as our Margin of Safety price:
Remember: we want to be as conservative as possible whenever we’re assessing a company. We can look at the past growth rates, and the current trend of those growth rates and come to a reasonable future growth rate. The more conservative we are, the less likely we’ll lose money if we are able to buy it at that price. Buffett’s #1 rule is Don’t Lose Money, and it is ours as well. That’s why we must demand a large Margin of safety.
The default growth rate they have in the calculator is what the analysts expect the business to grow at over the next few years. Based on the past, I think this number is reasonable and will leave it as is. As Next Level Investors, we don’t accept anything less than 15% per year from our investments, so we set that as our discount rate.
As you can clearly see, the current fair value for Home Depot is $97.92.
More than $55 less than the current share price. What this means is, in order for us to get a 15% return over the next 10 years+, we need to pay nothing more than $97.92.
Simple as that.
Wait, what about the dividend?
Excellent observation! If we expect a 2.3% dividend to continue into the future, we could subtract that number against our Next Level minimum of 15%. You’d have to do some digging to find out that they have raised their dividend by close to 20% over the last 3 years, and pay out a safe 44% of their cash to pay investors that dividend. With a Free Cash Flow growth rate of 15%, I’d say that dividend is very safe, and likely will grow into the future. But, we must be conservative, so we’ll stick with the current dividend yield of 2.3% (15% - 2.3% = 12.7%)
If we decide to include the dividend in our calculations, we now have a fair value of $117.55. This seems much more achievable doesn’t it?
But this is just our fair value price, and we as Next Level Investors never want to pay full price for any investment we make. In fact we want to pay half that.
Margin of safety
A simple way to calculate our Margin of safety price is to find our fair value price, and then cut it in half. That would give us a Margin of Safety price of:
$58.78
Youch. We’re a long ways off from buying at that price. In fact, this price hasn’t been seen since January 2013.
Now let’s check to see if this number is reasonable for the real world. In other words, how likely is it that if we’re patient, we get a chance to buy at this price or lower?
Looking back to see forward
Now we go to a site called Wolframalpha to check the Home Depot's past PE ratios, to see how far it drops during normal market fluctuations and Recessions.
There you have it, It looks like the average PE ratio over the last 10 years is 19.31. And it looks like it’s been a long time since Home Depot was on sale, garnering the lowest PE of 9.44 back in Oct of 2008.
What this tells me
This shows me that the market really like the stability and reliability of Home Depot’s earnings over the last 10 years, specifically over the last 5 years, where it’s channeled in the PE range of 19 to 25.
What this means for us as Next Level Investors is that we’d have to wait for another recession in order to buy Home Depot at a level that’s cheap enough to satisfy our Fair value calculations. The level I’d set this at is anytime Home Depot has a PE ratio of 11 or lower. This is when I’d be happy to be a buyer of this company.
The Next Level Investors Price for Home Depot
If we use that PE ratio of 11 that we easily hit multiple times during the last large market correction of 2008, we find that at today’s earnings numbers, we would have a Next Level Price of:
$73.48
Conclusion
I would not be a buyer at today’s price. Not even in the ballpark. To achieve a 15% return we could buy Home Depot at $117.55, but this is with no Margin of Safety built in, and therefore, all the risks that go along with that.
It may take some time for us to be able to buy Home Depot at the Next level price. But this is what it takes to be a successful investor over the long term. We have to be Certain we’re buying at a great price giving us the lowest downside risk, and the highest upside potential. This is our way to ensure we ‘Don’t Lose Money’ and in fact will lead us to riches. If you want to find the Next level Price of Home Depot at any given time, simply multiply Home Depot’s EPS number by 11.
That was fun!
I hope you enjoyed it.
We’ll talk again soon,
~Ryan Chudyk~
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