What's the deal with the Fool and Home Depot
Before taking up my task as the skunk at the garden party, let's briefly review the optimistic case for Home Depot. The bulls point to its relatively low trailing P/E ratio of 16.8, which has bottomed out after falling from the mid-40s during the early 1990s. With earnings per share growth at 13% and an excellent return on equity of 21.6%, many argue that a market inefficiency has been discovered.
Next, the upbeat analysts offer a valuation of Home Depot that puts its stock at around $44 per share -- once again the company's high growth rates are given maximum emphasis. Finally, concerns about the possibility of a housing bubble are raised, then promptly dismissed. With the stock currently trading at $39.50, an intrinsic value of $44 would yield a 10% gain for an investor in addition to the 1% dividend yield. At this point, the bulls rest their case. QED.
Let's now consider each point one by one. Yes, Home Depot's P/E ratio is declining, but this has been true for the industry as a whole, which sports an average P/E of around 14. This seems to indicate that the market expects lower growth in the future for this industry. These lower growth forecasts are reflected in stagnant share prices, which in turn lead to lower P/E ratios. The notion that Home Depot's stock price will jump and thereby bring its P/E ratio into line with a historical average seems a bit fanciful to me.
And valuing the company's shares at $44? My own valuation, using a discount rate of 10% (which is lower than the one used by Philip, I should add) and reasonable growth estimates, puts this stock at around $37. The current price of $39.50 seems like a fair valuation of these shares to me.
The real elephant in the room in regard to this stock, however, is the current state of the housing market. Alan Greenspan recently commented that he didn't think there was a national bubble in housing prices, but that there were "signs of froth in some local markets where home prices seem to have risen to unsustainable levels." As housing prices in these areas continue to soar, many homeowners have been using their appreciating assets as giant ATM machines, which have allowed them to fund vast home improvement projects worthy of a Renaissance merchant prince. Can this continue? I honestly don't know.
It seems to me that the uncertainty surrounding macroeconomic factors like interest rates, housing prices, and consumer spending data is keeping Home Depot's share price at its current level. Does it seem unrealistic to think that home prices might cool off, and Americans might trim their home improvement budgets for a few years? I'll let the bulls answer that one.
No discussion of Home Depot would be complete without touching briefly on its home improvement doppelganger, Lowe's
Home Depot has had an amazing run over the last decade. I hope my pessimism is misplaced and that investors in this stock reap the gains that so many observers are forecasting. Seth, Philip, and Don are all fine analysts, so it wouldn't surprise me if I'm wrong on this one. In any event, it looks like everyone's having such a good time at this party that it's doubtful they will notice a little old skunk.
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John Reeves does not own shares in any of the companies mentioned. Click here to see The Motley Fool's disclosure policy.