What if you knew?

What if you knew what the future held? Would it matter? If I told you that I could peer into my magic eight-ball and tell you how a company was going to perform financially over the next 10 years, would that make you any more or less capable of valuing its shares today and making a proper investment decision?

"Outlook not so good."

I've been blessed, not with remarkable foresight, but perfect 20/20 hindsight. And, rather than attempt the relatively impossible (forecasting anything 10 years into the future), I thought it would be interesting to look 10 years in the past at a remarkably stable and pretty predictable business we all know: Home Depot (NYSE:HD).

Through the magic of the SEC's searchable database of Home Depot's company filings, we're able to take a trip in the "way-back" machine to the end of fiscal 1993. At the time, Home Depot sported an $18.4 billion market capitalization. Today, Home Depot shares sit perched at $80.6 billion.

If you'd held Home Depot shares for these past 10 years, you'd have earned a return of $16%, plus dividends. Pretty darn good, especially when you consider that back in 1993 the 30-year Treasury bond was yielding 6.3% and the gap between stock prices and bond prices had been around 5.5%. For all intents and purposes, it was reasonable for you to expect an 11.8% return on your stock investments, and Home Depot has delivered 16%, plus dividends. Put quite simply, Home Depot has been an exceptional 10-year investment for those who held the stock.

The real question, however, is not about Home Depot's greatness as an investment, but whether you'd have ever owned it using widely accepted valuation techniques.

What do I mean? Well, when we have to make decisions about stock purchases, the more steadfast amongst us do complex calculations and make their best guess at the future value of cash flows, etc. Most hardcore stock analysts will tell you that the current value of any stock should be the value of the company's future cash flows, discounted back to some net present value. This is a pretty widely accepted method of valuing a stock. How did the market do at valuing Home Depot back in 1993?

Looking at the SEC filings, Home Depot has reported steady cash flow growth for the past 10 years. I didn't use free cash flow, which includes capital expenditures, simply because the company has continued to invest significant portions of its cash flow in building new stores. That won't last forever. Instead, I looked at cash flow, defined as net earnings plus depreciation and amortization. In the past 10 years, Home Depot has raked in just under $26 billion in cash flow.

Remember, back in 1993, the company was valued at $18.4 billion. Using a discount rate of 11.8% and Home Depot's actual cash flow results, I discounted the $26 billion back to 1993 dollars and came up with a valuation of $12.1 billion. Now, any reasonable person might tell you that looking at 10 years worth of cash flow and discounting it back to the present is a good measure for benchmarking a company's valuation. Doing that for Home Depot would have led you to the conclusion that in 1993, HD shares were 50% overvalued based on a 10-year discounted cash flow analysis.

So, is a 10-year time period the wrong number? Maybe so. But, if 10 years is wrong, what's right? Assuming that not much changes with the HD story in the next few years, it looks like 14 years would have been the right period of cash flow growth to justify a 1993 valuation of $18 billion. Seems kind of arbitrary, doesn't it? Heck, what if you used 30 years? I tried that too, and scaled down the growth rate in cash flows until I reached a "terminal" growth rate of 7% in cash flow growth. Using 30 years of forecasted cash flow data, the 1993 valuation of Home Depot would have been $46 billion, representing a 60% undervaluation of the business. My head hurts. Ten years, 14 years, 30 years? ARGH!

The problem
Home Depot is currently valued at $80 billion, nowhere near even the most far-reaching future cash flow projections you might have had back in 1993, and that's knowing the first 10 years for sure!

Okay, fine. Maybe 14 years is the right time frame. If so, what does it say about Home Depot's valuation today relative to the cash flows I think it will earn in the next 14 years? Well, I assumed that HD will grow cash flows at 15% for the next five years, 10% for the following five years, and 7% for the final four years. Your mileage may vary.

Using these numbers, I get a current valuation of $84 billion for HD, or about 5% from current levels. Wait, maybe I should use 10 years now that the business is more mature than it was. Hmmm, that's $59 billion. Darn, what if the correct number of years to project and use is 30? That would be $128 billion. DOUBLE ARGH!!

Okay, I hope by now you understand the point of my article today. Even knowing for sure what the first 10 years of Home Depot's cash flow would look like, it was still unclear how long to actually project to "get the right number."

The answer, of course, is to calculate multiple time frames and establish a range of potential valuations for your company, based on several time periods. Use 10 years and Home Depot might seem overvalued. Use 30 years and it might seem 50% undervalued. Use 14 years and, like baby bear's porridge, it will seem just right. Additionally, you should run similar valuation ranges on competitors like Lowe's (NYSE:LOW) to see if the two companies are being similarly valued, or if one is out of step.

Just know this -- the further out you have to go to make today's valuation look "right," the more nervous you should be. Conversely, the faster your company can generate the cash flows required to make today's market capitalization look reasonable, the more attractive that investment will be.

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David Forrest loved the poinsettia he bought from Home Depot, but is still angry at them for not stocking Ironite lawn care products. He doesn't own shares of the giant retailer or any of its competitors. The Motley Fool is investors writing for investors.