6 4 Associated CointreeAlex on 01/02/2022 - 14:07 cointree.com (142...Read More
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Whenever possible, I try to build in most investing lessons I have to share into examples using individual stocks. Sometimes I start with the lesson in mind, and then find a good individual stock to serve as an example, and other times I start by examining an individual stock and then zoom in on some aspect of it I think is important which can also apply to other stocks that are in a similar situation. One important concept that tends to come up implicitly in the comment sections of many of my articles is the question of what each investor's return goals are (though rarely does it come up explicitly). One's return goals are a very important consideration that doesn't get enough attention. So, in this article, along with sharing my standard valuation process for Home Depot ( NYSE:HD ) stock, I'm also going to touch on the topic of return goals as well, and how those can play a major role in how to treat the valuation of a stock like Home Depot. I've only written on Home Depot once before back in 2019, where I rated the stock a "Hold". It has performed roughly the same as the SP 500 since then so that was probably a reasonably accurate assessment at the time.
Data by YCharts
My valuation process has become a little more refined since mid-2019, but at its core, it's largely the same. Basically, what I do is to try to figure out, via a combination of P/E mean reversion, earnings yield, and earnings growth expectations, what sort of long-term CAGR we might expect from Home Depot stock if purchased at today's prices and held for 10 years. And then I use that rough CAGR expectation in order to compare the stock against my return goals to determine at what price I would be willing to buy it.
This article will do three things. First, I will run through my normal valuation process for Home Depot stock. Then, I will consider some adjustments that I think are reasonable to consider for that estimate. And lastly, I write about how each investor's return goals will color when Home Depot stock looks attractive as an investment. I will also include a dividend analysis as well.
Let's start with the basic analysis.
Before I begin an analysis, I always check the business's long-term earnings patterns in order to ensure that the business is a proper fit for this sort of earnings analysis. If the historical earnings 1) don't have a long enough history 2) are erratic in nature, or 3) are too cyclical, then I either avoid analyzing the stock altogether or I use a different type of analysis that is more appropriate for the stock.
Over the past twenty years, Home Depot has grown its earnings per share in every year except for the three years during the great financial crisis of 2007, 2008, and 2009. At that time, in those cumulative three calendar years, Home Depot's EPS growth fell a little more than -40%. My general guideline for whether to declare a stock a "deep cyclical" stock is that earnings tend to fall -50% or more during downcycles, so I don't consider Home Depot a "deep cyclical" stock. That said, it does have moderate-to-deep earnings cyclicality historically, and since the 2020 recession was unusual in nature and we haven't had a "normal" recession since 2009, it's important to realize that if we have a recession, Home Depot's earnings growth is likely to be negative. It probably won't be as bad as 2007-2009, but most analyses being done today (including the basic analysis I'm going to start with in this article) probably won't build in this sort of earnings growth decline into their long-term earnings growth calculations. However, I think as long as we make that adjustment at some point in our analysis, it's fine to use my normal "Full-Cycle Analysis" with this business, so that's what I'll do in this article.
In order to estimate what sort of returns we might expect over the next 10 years, let's begin by examining what return we could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. Since we have had a recent recession (albeit an unusual one), I'm starting this cycle in fiscal year 2015 and running it through 2023's estimates.
Home Depot's average P/E from 2015 to the present has been about 22.35 (the blue bar circled in gold on the FAST Graphs). Using 2023's forward earnings estimates of $16.55 (also circled in gold), Home Depot has a current P/E of 17.71. If that 17.71 P/E were to revert to the average P/E of 22.35 over the course of the next 10 years and everything else was held the same, Home Depot's price would rise and it would produce a 10-Year CAGR of +2.34%. That's the annual return we can expect from sentiment mean reversion if it takes 10 years to revert. If it takes less time to revert, the return would be higher.
We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected, to the performance of the actual business. In this section, we will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today's prices and kept all of the earnings for ourselves.
There are two main components of this: the first is the earnings yield and the second is the rate at which the earnings can be expected to grow. Let's start with the earnings yield (which is an inverted P/E ratio, so, the Earnings/Price ratio). The current earnings yield is about +5.64%. The way I like to think about this is, if I bought the company's whole business right now for $100, I would earn $5.64 per year on my investment if earnings remained the same for the next 10 years.
The next step is to estimate the company's earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the EPS growth rate since 2015, taking into account each year's EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).
Data by YCharts
Home Depot has repurchased a lot of stock over the past 20 years (ironically, except when the stock price is falling deeply during recessions, as in 2008 and 2020) and these buybacks have contributed to steady and relatively high EPS growth. Since 2015 alone, they have bought back about 1/5th of the company. I will back these buybacks out when estimating earnings growth. After doing that I get an earnings growth estimate of +14.93% since 2015.
Next, I'll apply that growth rate to current earnings, looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought Home Depot's whole business for $100, it would pay me back $5.64 plus +14.93% growth the first year, and that amount would grow at +14.93% per year for 10 years after that. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $230.96 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +8.73% 10-year CAGR estimate for the expected business earnings returns.
Potential future returns can come from two main places: market sentiment returns or business earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for Home Depot, it will produce a +2.34% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +8.73% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +11.07% at today's price.
My Buy/Sell/Hold range for this category of stocks is: above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. That makes Home Depot undervalued, and currently a "Hold", but very close to my buying threshold of 12%, and if the price fell to about $277, it would cross that buying threshold. However, I think my basic analysis here is very optimistic for several reasons that I'll explain in the next section.
Whenever a stock gets close to my standard buy price I always like to put my assumptions under some additional scrutiny. Usually, this involves zooming out and asking the question of whether my basic assumptions are reasonable or not, and considering any clear dangers ahead that might not be built into those assumptions.
The first warning sign for investors is that analysts who cover the stock are expecting 6-7% EPS growth in fiscal years 2023, 2024, and 2025. And this likely includes the effects of stock buybacks. So, really, if we take the buyback out, analysts probably expect 5% organic earnings growth going forward. That's about 1/3rd of the growth rate since 2015, which was what I used in my initial analysis of the stock. I can't emphasize enough that it's very rare to see this sort of conservatism on the part of analysts when the previous earnings growth history has been so strong. However, when we take a closer look and apply some context, I think these conservative estimates make sense.
First, from fiscal year 2015 to 2018, EPS growth was steadily declining from 22% to 16% (even more if we removed the buybacks). But in the calendar year 2018 (fiscal 2019), we had corporate tax cuts, and that clearly helped Home Depot's earnings growth that year. While EPS grew 33% that year, revenue only grew 7.23%.
Data by YCharts
So, this 33% EPS growth year in fiscal 2019 was likely a one-year EPS growth outlier.
Then in fiscal 2021 and 2022, we had massive government stimulus and an exodus out of cities and into suburbia and the countryside. This combination likely created two more years of unusually high EPS growth, while the year in between only saw 4% EPS growth. Putting this all together, I think analysts' estimates for the next three years of EPS growth are likely very reasonable estimates.
If I were to use a 7% earnings growth rate assumption instead of the +14.93% assumption in my basic analysis I would get a 10-year CAGR of +8.13%, which is right at the midpoint of fair value for me, if everything else was held constant, and much farther away from being a "buy" in my book. However, slower earnings growth is not the only danger with Home Depot stock.
The additional danger is that my basic analysis did not take into account a "normal" recession. Home Depot's earnings fell over -40% from 2007-2009. That was a deep recession that affected HD's end consumers a lot so earnings might not fall that far during the next recession, but I think it's reasonable to assume two years of decline with a cumulative earnings decline of -30% during an average recession (which is sure to happen at some point over the next 10 years). If that recession were to happen within 2-3 years from now and we included it in our cumulative earnings growth estimate, the earnings growth rate CAGR for cumulative earnings over 10 years would fall to +2.58%. And if we use that earnings growth rate assumption, we get a 10-year CAGR expectation of +7.04%. Still close to fair value, but there are likely knock-on effects of a growth rate that 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. For that reason, I think we need to forget about the mean reversion portion of the estimate. Mean reversion typically can only be counted on for stocks whose earnings are growing at a similar rate as they had in the past. If we remove the +2.34% mean reversion expectation, then we get an expected 10-year CAGR of +4.70%, which is much closer to being a "Sell" than it is a "Buy". Using these assumptions and removing the mean reversion, Home Depot stock would need to fall to about $138 per share before it would become a "buy" for me.
Because Home Depot has a pretty long history of paying a consistent dividend and appears to have many dividend investors interested in the stock, I thought I would include a dividend analysis here as well. One of the benefits of a dividend analysis is that dividends are likely to keep rising over the next decade, even if earnings growth slows as I expect it to. Also, depending on what assumptions I make about earnings and recessions, my typical analysis is giving a very wide range of results. A dividend analysis might be able to tilt our outlook on which end of that range makes the most sense.
Below is my standard explanation of my reason for using time until payback analysis:
When it comes to the vast majority of individual stocks, risk increases with time. This situation is different for major stock indexes, where the longer one holds a major index like the SP 500, the more likely it is their investment will succeed and produce positive returns. Many investors do not understand this very important distinction. The reason risk increases with time for individual stocks is because it becomes more difficult to predict the future the farther out in time we go. For example, analysts will probably be much closer to predicting a business's earnings next quarter than they will be predicting it in the same quarter 10 years from now. And I have zero confidence an analyst can predict what earnings will be 20 years from now. Whereas, when it comes to the SP 500, an analyst might be able to get pretty close to predicting long-term earnings because the earnings average out over time to a somewhat predictable level. This fundamental fact when it comes to individual stocks is rarely, if ever, taken into account with traditional analysis like a DCF or dividend discount model, or most other models of dividend valuation. But it should be.
What I set out to do with the form of analysis I will share in this article is to integrate the time-risk into the analysis. And the way I have done that is to frame the valuation question in terms of how long it is likely to take an investor to earn an amount equal to their investment in a stock back, strictly from dividends and dividend growth over time. In other words, if you invest $100 into a stock, what I want to know is how long it will take to earn $100 back only from the dividends. I call this measurement "Dividend Time Until Payback".
Whether a dividend stock is a good value or not is then based on how far out an investor thinks they can forecast into the future and what they expect to earn in dividends. The time-risk will be subjective for each investor and might vary from stock to stock. But, my view is that for most reasonably high-quality stocks like those in the SP 500 index, I can probably do a good job forecasting out 10 years into the future, so if I can earn my money back in that amount of time, then it's likely to be a good dividend investment including time-risk into the equation. On the high end, other than maybe Berkshire Hathaway (BRK.A) (BRK.B), I don't feel confident predicting the future of any individual stock 20 years into the future or more. So, any dividend stock that looks to take more time than that to pay me back an amount equal to my investment is too risky for me because the risk of disruption, competition, or changing consumer demand over the course of 20 years is too high. And in between 10 and 20 years is a range of payback periods where an investor might be able to make the case of making small adjustments for individual circumstances of each business depending on their predictability. But I think it's fair to say any dividend stock that takes over 15 years to pay back an amount equal to its investment probably isn't a "buy", but perhaps, depending on other factors (like prevailing interest rates, inflation expectations, stability of the industry, etc.), individual cases can be made for those stocks that fall in the 11-14 years range.
Putting all this together, I think it's fair to create a valuation range using dividend time until payback where 10 years or under is a "Buy", 11-14 years is a fairly valued "Hold", 15-19 years is a "Hold", but overvalued, and 20 years and over is a "Sell" if there are better alternatives that can be found in the market.
In order to estimate how long it would take to earn our investment amount back via dividends, we first need to estimate what the starting dividend yield is, and then also estimate what the dividend growth rate is likely to be. Since most good companies' dividends often rise year over year, I pull forward dividends expected for the current year rather than use the trailing twelve-month dividends.
If we assume Home Depot pays out $7.59 in dividends this year, then the current dividend yield is about 2.51%.
Next, we need to estimate how fast this dividend is likely to grow over time. This requires a little more judgment. Since I am using very long-term projections in most cases, I never want to assume that dividend growth, over the very long term, will exceed earnings growth (because dividends come from earnings). That said, there are situations where if a payout ratio is relatively low, dividend growth can potentially exceed earnings growth for some period of time. So, what I do, is if the payout ratio is under 50%, and dividends are growing faster than earnings, then I will blend the two growth rates together and use that as our dividend growth rate estimate. But if the payout ratio is above 50%, I will cap dividend growth rate expectations at whatever the earnings growth rate expectation is.
For Home Depot, unlike price movements, which can happen over a short period of time, we know it's going to take a long time to earn our investment back via dividends. For that reason, I am going to assume there will be a recession at some point that causes a -30% decline in earnings, and I will also assume during normal years Home Depot's earnings will grow 7% as I did with the earlier analysis. This produces a full-cycle earnings growth estimate of +2.34%. However, I will keep Home Depot's very fast dividend growth rate CAGR since 2015 of +19.76%, and since the payout ratio is about 45% and that is under 50%, I will average these two growth estimates together (2.34% and 19.76%) and assume a long-term dividend growth rate +11.05% (which to me seems very reasonable).
Ultimately, what I am interested in estimating is how long it would take to earn $100 on a theoretical investment of $100 via only dividends. We can do this by taking the current dividend yield of 2.51% and applying that to $100, which would pay us out $2.51 per year if the dividend never grew. But, we expect the dividend to grow at about +11.05% each year, so we need to take that into account as well. I assume that this money is collected by the investor and not reinvested in the stock and I go ahead and pull the first year's dividend growth forward. So, at the end of the first year, I assume we would get paid $2.78 on our $100 investment. This process continues for however long it takes to collect $100 worth of dividends and when it crosses that threshold, it will be our "Dividend Time Until Payback" as measured in years. Using this method, it will take about 16 years to earn our money back via only dividends with Home Depot stock.
For me, a 16-year time until dividend payback is on the expensive side, but since most dividend stocks are very expensive right now, Home Depot is actually still more attractive than 75% of the high-quality dividend universe of stocks. The price would need to drop to about $144 per share to produce my preferred 10-year time until payback. (This is pretty close to my $138 buy price using my most conservative estimates on the full-cycle analysis.) And this is a little more than a -50% drawdown from where the stock trades today.
Data by YCharts
That would end up being a little bit deeper drawdown than the stock experienced during the Great Recession in the chart above, however, at Home Depot's peak before going into the Great Recession it traded at a P/E of around 15. The peak P/E it hit this time was nearly double that, at around 28. That's a lot of potential multiple compression that could add to a price decline in a recession scenario for Home Depot. This creates a situation where the next recession doesn't have to be as bad as the Great Recession in order to cause a deep drawdown in Home Depot's stock price.
Alright, I've examined Home Depot stock from a variety of different angles, and it looks to me like somewhere under $150 per share, or about half of where it trades at now, it would be low enough for me to buy. I'm sure many investors reading this article think Home Depot stock will never fall that low. And to that, I have a couple of responses. The first is that my "buy prices" are not the traditional "price targets" you see from analysts. I am not predicting Home Depot stock will necessarily fall that low. What I am saying is if it does fall that low, I'll probably buy the stock. I don't have a jar of money marked "Home Depot Stock" waiting to invest only in Home Depot that will go to waste if the price never hits the price I'm looking for. Instead, I have a pool of cash, and I watch about 600 stocks every day in order to see if any of them hit my buy prices. And, given the amount of cash I have right now, if I can get 30-40 to hit out of the 600 over the next two years, then I'll be in very good shape.
That doesn't mean everyone has to have the same buy prices that I do and that one buy price is right and another is wrong. This is where one's return goals and expectations come into play. Assuming we don't have a depression or hyperinflation, my goal is to try to achieve overall portfolio level returns in the range of 15% to 20% per year on average over the long term. That's roughly 50% to 100% better than the average long-term returns of the SP 500 index and about equal to or -25% lower than the long-term returns of Berkshire Hathaway. Because I'm aiming for high returns, I pretty much mathematically need to buy stocks when they are very cheap. Or, I need to identify very good long-term winners early. Or, I need to understand when we are near the top of an economic cycle or near the bottom. And I try to do all of these things, none of which are particularly easy for the average investor to do.
Importantly, though, not every investor is aiming for such high returns. Some investors just want market returns, and so they index. Other investors only care about the income produced from the assets and not the asset prices themselves, so they focus only on income and dividends. There are investors who are very happy to highlight that their dividend returns average 7% to 8% per year. I am not one of those investors. First, I don't care whether my returns come from dividends or capital gains or whether they are realized or not. I will take the returns in whatever form I can get them. But under normal circumstances, I want 15% to 20% long-term annual returns. Most investors do not aim for returns that high.
This creates a situation where if we think of the market as basically an auction of future returns. The auctioneer starts off the bidding at a 1% annual return for each stock, and then if there are no bidders raises the return to 2%, and continues this process until all of the stocks in the market are sold each day. Even if each investor had perfect knowledge of what the future return would be, depending on each investor's required return, they might be able to buy a stock on any given day, or they might not if all the stocks get sold before their required return is met. If there are lots of investors willing to accept low future returns, then someone like myself might not get the chance to buy something with the high future returns I'm looking for. Fortunately, we don't know what the future returns will be for any given stock, so, combined with external economic conditions and the fact that many investors limit themselves to certain categories of stocks (like dividend-payers, or fast growth, or tech, or non-cyclical, or only U.S. stocks...), and also that many traders do not care about long-term future returns at all, means that every now and then I do get the opportunity to buy stocks with high return potential. Nevertheless, I am always at the mercy of other investors who are willing to accept a lower future return than I am. That's just the way it is.
My point here is that assuming we have a high-quality business that is likely to produce some future return over the medium or long-term, as we do with Home Depot, there isn't necessarily a "wrong" price to buy it. If an investor is happy with a 2.51% dividend yield that grows at 11% per year for the next decade, and that meets their goals, then more power to them if they want to buy the stock here. I'm just aiming for higher returns than that. So I will wait.
A lot regarding Home Depot stock's performance over the next three years depends on whether we have a bear market and a recession or not. I think the odds of a recession are high, and so I think my base-case for the stock is that it falls another -30% to -35% from here at some point over the next few 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 overall market, though, and if we avoid a recession, while the returns probably won't be spectacular, it will likely do okay. For that reason, I'm rating the stock a "Hold" here even though I think there are risks that aren't priced into the stock, yet, because stocks with similar profiles aren't any cheaper than Home Depot at the moment and it's hard to judge how deep or mild a recession might be even if it happens.
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6 4 Associated CointreeAlex on 01/02/2022 - 14:07 cointree.com (142...Read More