When the market has a significant sell-off, just about every stock -- deservedly or not -- gets dragged down along with it. This can create buying opportunities for fantastic businesses or value traps for struggling ones.
In the case of a historically winning stock like Home Depot (HD -0.23%), which has been beaten down over the past year, it's worth taking a deeper dive into the business. Here's a look at what's happening with the largest home improvement retailer and whether its stock is a buying opportunity or a value trap.
Why Home Depot stock is down
Housing is a fundamental need in good times and in bad. However, in a high-interest rate environment, people are generally less willing to buy new homes and to upgrade their current ones. As a result, management at Home Depot has guided for flat sales and a decline in diluted earnings per share in 2023 compared to 2022.
Home Depot also faces growing merchandise inventory as consumers tighten their spending. The home improvement retailer had $24.9 billion in inventory at the end of 2022, an increase of $2.8 billion or nearly 13% from the prior year.
With excess inventory, Home Depot might be forced to give deep discounts to unload goods or face elevated costs to store them. In either scenario, gross margins will decrease as the cost of goods sold goes up and revenue declines, negatively affecting profit farther down the balance sheet.
With poor guidance announced and inventory piling up, Home Depot stock is down roughly 8.7% for 2023 and 13% over the past 12 months.
Why Home Depot could bounce back
Two undeniable long-term trends favor Home Depot: America has a shortage of houses, and its current housing supply is old.
After the Great Recession, new housing developments screeched to a halt. Over the past decade, an estimated 15.6 million households were formed in the U.S., but only 13.3 million housing units were started, creating a gap of 2.3 million homes. So even in an uncertain macro environment, homebuilders can confidently build homes over the coming decade, knowing demand outweighs supply.
At least 50% of American household units are more than 40 years old, according to the 2020 U.S. Census. That means many homeowners might need to pay for major repairs or ongoing maintenance. And with the average housing price appreciating 40% since the start of the pandemic, many homeowners can tap their home equity for an upgrade, although higher interest rates could discourage some.
As the largest home improvement retailer in the United States by market cap, Home Depot is set up for long-term growth because of these two trends. That should remain true even if it faces short-term challenges.
Is Home Depot stock a buy?
Home Depot is a high-paying dividend stock, and it recently raised its quarterly dividend by 10% to $2.09 per share, equating to a dividend yield of about 2.7%. Shareholders should expect more dividend raises in the future, since management has paid and raised the dividend each year since 2009.
Additionally, with the sluggish stock price over the past month, Home Depot's shares appear to be discounted compared to their historical valuation. Currently, the stock trades at a price-to-earnings (P/E) ratio -- a common valuation metric -- of roughly 17. Over the past five years, Home Depot has had an average P/E of about 22.
The bottom line is that investors shouldn't ignore Home Depot's short-term challenges. Still, the largest home improvement retailer is well-positioned to return to sales growth over the coming decade, and it will pay you handsomely in dividends as you wait for the paint to dry.
