When I can, I attempt to build in most investing lessons I’m required to discuss into examples using specific stocks. Sometimes, I have the lessons in mind and then locate a good individual stock to serve as an example, and other times I start by examining an individual stock, and then focus on some aspect of it I think is important which can also be applied to other stocks that are in a similar situation. One important concept that tends to come up often in the comments section in a lot of my articles is the question of what the goals of each investor are (though very rarely is it brought out in the open). One’s return goals are a crucial aspect which isn’t getting enough attention. So, in this article I’ll also share my standard valuation process of Home Depot (NYSE:HD) stock as well, I’ll briefly discuss return goals too and how they can be a significant factor in how to treat the valuation of a stock such as Home Depot. I’ve only written about Home Depot once before back in 2019, where I gave the stock at a “Hold”. The stock has been roughly same as the S&P 500 since then so it was likely an exact assessment back then.
My method of valuing has become more refined since mid-2019, but in the end, it’s still largely similar. The way I approach it is to try to determine, using the combination of P/E mean reversion, earnings yield, and earnings growth expectations as well as what type of long-term CAGR we might anticipate for Home Depot stock if purchased at today’s price and kept over a period of 10 years. Then, I utilize that rough CAGR expectation in order to evaluate the stock against my returns goals and determine at what cost I’d be willing to purchase it.
This article will accomplish three things. First, I will go through my usual valuation process to determine the value of Home Depot stock. After that, I’ll consider some adjustments that I think are appropriate to make to arrive at that figure. In the final section, I will describe how each investor’s expectations for returns will impact when Home Depot stock looks attractive as an investment. I’ll also provide an analysis of dividends.
Let’s start with the basic analysis.
How Cyclical is Home Depot’s business?
Before I begin an analysis, I examine the company’s long-term earnings patterns in order to make sure that the company is a proper fit to perform this type of analysis. When the earnings history 1) don’t have a lengthy enough history 2) are not consistent in nature, or) appear to be too unpredictable, then I choose to either not analyze the stock at all or employ a different method of analysis that is more appropriate for the particular stock.
In the last twenty year, Home Depot has grown its earnings per share in each year, excluding the three years following the massive financial crisis of 2007 2008 and 2009. In the total of those three calendar years the growth in EPS for Home Depot was a little less than 40%. My general rule of thumb on whether to consider a stock to be classified as a “deep cycle” stocks is its earnings generally fall by up to -50% or more in downtimes, and I do not think that Home Depot a “deep cyclical” stock. But, it has a moderate to deep earnings cyclicality historically. Moreover, since the 2020 recession was unusual in nature and we haven’t had an “normal” recession in the last few years, it’s crucial to recognize that if we have a recession, Home Depot’s earnings growth is likely to be negative. The odds aren’t the same as 2007-2009 however the majority of analysis being conducted in the present (including the one I’m going to begin on in this piece) likely won’t factor in this type of earnings decrease into their long-term earnings growth estimates. However, I believe that in the event that we are able to make this adjustment at some point in the analysis, we’re able to utilize my regular “Full-Cycle Analysis” in this case this is exactly the plan I’ll use in this article.
Market Sentiment Return Expectations
In order to estimate the type of returns we could expect over the next 10 years, let’s start by looking at the kind of return that we could see in the next 10 years if the P/E number returned to its normal value from the previous economic cycle. Because we’ve experienced a recent recession (albeit not a typical one) I’m beginning this cycle with fiscal year 2015 and running through 2023’s estimates.
Home Depot’s average P/E from 2015 until the present is 22.35 (the blue line is circled in gold on the FAST Graphs). Using 2023’s forward earnings estimates of $16.55 (also marked using gold), Home Depot has the current P/E at 17.71. If the 17.71 P/E was to fall to the average of 22.35 over the next 10 years, and all other factors were held the same, Home Depot’s price would increase and produce a 10-Year CAGR of +2.34 percent. That’s the annual return we can expect from sentiment mean reversion when it takes 10 years to revert. If it takes less time to revert to a more favourable state, the return would be greater.
Business Earnings Expectations
We’ve previously looked at what would take place if the market’s sentiment changed to its mean. It is completely affected by its mood and is usually not linked or at best, not connected to the actual performance of the business. In this section we will analyze the actual income of the company. The objective here is simple: We want to know 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 kept all of the profits for us.
There are two major elements of this: the first is the yield on earnings and the second one is what rate the earnings are expected to increase. Let’s look at the earnings yield (which is an inverted P/E ratio, so, the Earnings/Price ratio). The current yield for earnings is approximately +5.64 percent. One way I like to think about this isthat in the event that I purchased the company’s entire business today for $100, I’d make $5.64 per year on my investment if the earnings were constant for the next 10 years.
The next step is to calculate the growth in earnings of the company during this time period. I do this by figuring out how much earnings increased in the last cycle, and then applying that rate to the following 10 years. This is accomplished by calculating the earnings increase since 2015 by taking into account the growth in EPS for each year, or decline, and then securing any share buybacks over that time period (because reducing shares will increase the EPS due to fewer shares).
Home Depot has repurchased a number of shares over the last 20 years (ironically with the exception of when the stock price falls deeply during recessions, as in the years between 2008 and 2020) and these buybacks have contributed to an EPS that has been steady and fairly high growth. In the last year all of them, they’ve bought back around 1/5th of the company. I’ll take these buybacks when estimating growth in earnings. After doing that I get an estimate for earnings growth of +14.93 percent since 2015.
Then, I’ll apply the growth rate to the current earnings in the future, looking 10 years ahead to arrive at an estimated CAGR for the 10 years to come. The way I see this is that if I bought the entire Home Depot business for $100 that would pay me in $5.64 plus +14.93 percent growth in the initial year, and that amount would grow at +14.93 percent per year for the next 10 years. I want to know how much I could earn in total at the end of 10 years from the $100 investment that I’m estimating to be approximately $230.96 (including the original $100). When I plug that number into an CAGR calculator, it translates to a +8.73% 10-year CAGR estimate of expected profits of a business.
10-Year, Full-Cycle CAGR Estimate
Future returns for potential investors can come from two primary sources that are: market sentiment return or the business earnings return. If we assume that the sentiment of the market goes back to the mean of the last cycle over this period of time for Home Depot, it will produce a +2.34% CAGR. If the growth rate and the yield are comparable to the previous cycle, then the company should achieve a +8.73% 10-year CAGR. If we add both of them together, we’ll get the expected 10-year full-cycle CAGR of +11.07% at today’s price.
My Buy/Sell/Hold range in this category of stocks is that anything above the 12% expected CAGR, it’s the definition of a Buy. Below a 4% expected CAGR is considered a Sell, and anything between 4% and 12% is considered a Hold. This leaves Home Depot undervalued, and currently considered a “Hold”, but very close to my threshold for buying of 12%. Moreover, when the price falls to about $277 this would mean it was close to the threshold of buying. But, I believe that my initial analysis is optimistic for several reasons that I’ll explain in the next section.
Additional Factors to Consider
Whenever a stock gets close to my average purchase price, I like to place my beliefs under some further scrutiny. Typically, this involves zooming out and asking whether my basic assumptions are reasonable or not, and considering any potential risks that might not be built in those assumptions.
One of the first signs of concern in the eyes of investors would be the news that analyst who track the stock are anticipating 6-7% growth in EPS 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 probably expect 5% organic earnings growth in the coming years. It’s around 1/3rd of growth rate of 2015, which is the number I used for my initial assessment for the share. I cannot stress enough how rare it is to see this sort of caution from analysts, especially when the prior growth in earnings has been exceptionally impressive. But, if we take an in-depth look and apply certain contexts, I think this kind of conservative estimate is logical.
From the fiscal year of 2015 until the year 2018 EPS growth was consistently declining from 22% to 16% (even more if we removed buybacks). However, in calendar year in 2018 (fiscal 2019) we enjoyed corporate tax cuts that was a huge boost to Home Depot’s revenue growth in that year. Although EPS grew 33% the year before, revenue increased by 7.23 percent.
Thus, this 33 percent EPS growth year in fiscal 2019 is likely an anomaly in the EPS growth rate for one year.
In the years 2021 and 2022, we saw massive stimulus from the government and an exodus of people from cities to suburbia and the countryside. This combination likely created two additional years of unusually high EPS growth, while the period between had a 4% increase in EPS. If you take this all into consideration I believe that analysts’ forecasts for the coming three years of EPS growth are likely very reasonable estimates.
If I were to use an earnings growth of 7% rate as opposed to the +14.93 percentage assumption that I have used in my basic analysis I’d be able to calculate the 10-year CAGR to be +8.13 percent, which is right at the middle of fair value to me, when everything else is kept at the same level, and is further away from being an “buy” for me in my book. However, slower earnings growth is not the only danger associated with Home Depot stock.
Another risk is the fact that my analysis did not take into account a “normal” recession. Home Depot’s earnings dropped over -40% from 2007-2009. That was a deep recession that affected HD’s end consumers significantly, so earnings may not drop that much during the next recession, but I think it’s reasonable to consider two years of decline , with an overall decline of -30% for the average recession (which will surely occur in the course of 10 years). If that recession were to happen within 2-3 years and we added it to the cumulative growth rate estimate, the earnings growth rate CAGR for the cumulative earnings over the next 10 years would be +2.58 percent. If we apply that earnings growth rate assumption that we have a 10-year CAGR forecast of +7.04%. The stock is still within the fair value, however there could be knock-on effects 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 believe we should not be concerned about the mean-reversion portion of the forecast. Mean reversion is typically able to be a reliable indicator for stocks whose earnings are expanding at the same rate as they did before. If we remove the +2.34 percent mean reversion expectations and we are left with an expected 10-year CAGR +4.70 percent that is closer to being an “Sell” as opposed to an “Buy”. Based on these assumptions, and taking out the mean reversion Home Depot stock would need to fall to about $138 per share before it could be considered an “buy” for me.
Dividend Payback Analysis
Because Home Depot has a pretty long tradition of paying a constant dividend, and it appears to have plenty of dividend investors that are interested in the stock and I thought it would be a good idea to include a dividend analysis here as well. One benefit of the dividend analysis is that the dividends are expected to increase over the next decade, even if earnings growth slows , as I believe it to. Additionally, based on the assumptions I make regarding earnings and recessions my usual analysis yields a very wide range of outcomes. An analysis of dividends might help us to adjust our outlook on which end of that spectrum makes the most sense.
Thoughts On Returns Thresholds
Okay, I’ve looked at Home Depot stock from a various angles and it seems like somewhere under 150 cents per share or roughly 50% of the price it trades at right now, it’d be low enough for me to invest in. I’m sure that a lot of readers of this article believe Home Depot stock will never fall that low. And in response to that I’ve got a couple of responses. The first is that my “buy prices” do not correspond to the standard “price targets” you hear from analysts. I’m not saying that Home Depot stock will necessarily be that low. What I’m saying is that, if it happens to fall this low, I’ll most likely buy the stock. I don’t have a pot of money marked “Home Depot Stock” waiting to invest only into Home Depot that will go to waste if it isn’t what I’m hoping for. Instead, I’ve got an accumulation of cash and I keep an eye on around 600 stocks each day to determine if any of them hit my buying prices. Given the amount of cash I’m currently holding If I can manage to get 30-40 percent of the 600 stocks over these two years I’ll be in good position.
That doesn’t mean everyone has to buy at the same prices that I do and that one purchase price is correct and the other is not. This is where the return objectives and expectations become relevant. Assuming we don’t have a depression or hyperinflation, my aim is to achieve overall portfolio level returns that range from 15 percent to 20% per year , on average, over the long term. This is approximately 50% or more than the average long-term returns that are part of the S&P 500 index and about 25% or more below the long-term returns that are offered by Berkshire Hathaway. Since I’m trying to get high returns, I pretty often have to purchase stocks when they are very affordable. Or, I need to find very reliable long-term winners before they become too expensive. or, I have to know when we are at the peak of the economic cycle or near the bottom. And I try to do every one of them, none of which are particularly easy for the average investor to do.
However, not every investor is aiming for such high returns. Certain investors only want market returns, and so they use indexes. Others are only concerned with the income produced from the assets, not the prices , and so they focus only on dividends and income. Some investors are thrilled to point out that their dividend returns average between 7% and 8% each year. Personally, I’m not among the investors. The first thing I care about is about whether my gains come from capital gains or dividends or if they’re actually realized or not. I’ll be taking the profits in any way I can obtain them in. Under normal circumstances, I’d like 15 percent to 20% long-term annual returns. Many investors do not strive for such returns.
This creates a situation where you can think of the market as an auction for future returns. The auctioneer begins by bidding at 1 percent annual returns for each stock, then if there are no bidders raises the return to 2% and repeats the process until all stocks on the market are sold every day. If every investor was aware of exactly the expected future return be, contingent on each investor’s specific return they may be able to buy a share on some day but they might not be able to if all stocks are removed before their return is reached. If there are lots of investors willing to take on lower future returns, then someone like me may not have the chance to purchase an item that is likely to yield the high returns I’m hoping for. However, we do not know what the future returns will be for a particular stock, and this is combined with external economic conditions and the fact that a lot of investors are restricted to certain types of stocks (like dividend-paying stocks, or rapid growth, or technology, or non-cyclical, or only U.S. stocks …), and the fact the fact that most traders don’t pay attention to long-term future returns in any way, it which means that every once in a while, I get the chance to invest in stocks with the potential to earn high returns. Nevertheless, I am always being influenced by other investors who are more willing to take a lower return in the future than I are. It’s the way it is.
My main point is that, assuming that we own an extremely high-quality company that is likely to yield a yield over the medium or long-term similar to what we have when we work with Home Depot, there isn’t necessarily an “wrong” price to buy it. If an investor is content with an 2.51 per cent dividend yield which increases at 11% each year for the next decade, and that meets their goals, then more than they deserve in the event that they choose to purchase the stock here. I’m only looking for higher returns over that. Therefore, I’ll wait.
Conclusion
A lot of information about the Home Depot stock forecast over the next three years will depend on whether we are in a bear market and a recession. I believe the chances of a recession are extremely high, and so I think my most likely scenario on the shares is that it will fall further between -30% and -35% from here at some point in the next couple of years. If it falls more than -50% from here then I’ll 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 spectacular, it will likely perform well. For that reason, I’m giving it an “Hold” here even though I’m concerned about risks that aren’t priced into the stock, yet due to the fact that stocks with similar profiles aren’t any cheaper in comparison to Home Depot at the moment and it’s not easy to assess the severity or how mild the recession could be in the event of one.
Worlds First Content