Last fiscal year (ended Jan. 28), Home Depot (HD +3.61%) posted revenue of $152.7 billion and net income of $15.1 billion. Both of these key figures were significantly higher than they were just five years ago, as the business has held onto its market share gains.
This has helped the shares climb 89% in the last five years (as of Feb. 21), exceeding the performance of the S&P 500.
Investors looking to add this winning retail stock to their portfolios must first understand what might be Home Depot's biggest bear case.
Paying up for no growth
As of this writing, shares are trading hands at a price-to-earnings (P/E) ratio of 23.2. That's a bit more expensive than its trailing-five-year average of 21.6, and it represents a huge premium to the P/E multiple of 17.3 the stock carried at the end of October last year. Moreover, investors are being asked to pay more for Home Depot than they are for its smaller rival, Lowe's.
This elevated valuation seems unwarranted at first glance. In the latest fiscal quarter, the business reported same-store sales that declined 4% in the U.S., as overall revenue dropped 2.9%. This was after revenue increased by just 4.1% in fiscal 2022. Perhaps Home Depot's current valuation reflects the expectations that the company can return to the mid- to high-teens-percentage top-line gains that it registered in fiscal 2020 and 2021.
To be clear, the business has been facing macroeconomic headwinds for the past couple of years. After a surge in home renovation spending during the pandemic, things have cooled off. Inflationary pressures and higher interest rates discourage consumers from wanting to spend on big-ticket discretionary items to spruce up their living quarters. That's understandable.
According to Wall Street consensus analyst estimates, Home Depot's revenue and earnings per share are slated to grow at compound annual rates of 2.9% and 6.4%, respectively, over the next three years. That would be a notable deceleration from the previous three years.
Given the possibility of slower growth in the near term, I'd argue that the most compelling bear argument for why investors should avoid this stock centers squarely on its valuation being too high. Should the Wall Street forecasts come to fruition, the current setup limits the possibility of adequate forward returns.
NYSE: HD
Key Data Points
Always think long-term
There are always two sides to every story. While I'd agree that Home Depot's current P/E ratio doesn't necessarily scream that it's a bargain stock to buy without hesitation, I believe this high-quality business still deserves a closer look for your portfolio. This is especially true for long-term investors who can look out over the next five or 10 years.
With about 16% market share, Home Depot is by far the leader in the home improvement industry. Its scale, exemplified by more than 2,000 stores in the U.S. and sprawling logistics and fulfillment centers, make it almost impossible for much of the industry to compete effectively. As a result, the company should have no problem further penetrating what CEO Ted Decker estimates to be a "fragmented $950 billion-plus market."
Even better, the housing industry plays to Home Depot's benefit. The average age of a home in the U.S., a key indicator for the potential of home improvement activity, is 40 years. Additionally, it's estimated the U.S. has a housing shortage of about 3 million units, a trend that incentivizes home upgrades.
In the last three fiscal years, Home Depot has returned nearly $53 billion of capital to shareholders in the form of dividends and buybacks. This attractive capital allocation policy is set to continue indefinitely, thanks to the company's impressive profitability.
So, although the valuation looks steep initially, there are still many reasons to own the stock.
