Why Are Home Depot's Shares Up?

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Mar 04, 2015

In this article, let's take a look at The Home Depot, Inc. (HD, Financial), a $151.87 billion market cap company that is the world's largest home improvement retailer. The company operates a chain of more than 2,200 retail warehouse-type stores, selling a wide variety of home improvement products for the do-it-yourself and home remodeling markets.

Dividend hike and share repurchase program

The firm has an attractive dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis. We have favorable expectations regarding dividend growth, and why not share repurchases for the next few years?

It has announced a 26% increase in its quarterly dividend from 47 to 59 cents per share, which will generate an annualized dividend of $2.36 cents per share. With a closing price of $116.07, this makes an annualized dividend yield of 2.0%.

The hike followed strong earnings reported which were better than expected. This, of course, was not the first time history showed that, at periodic intervals, the company had its dividend increased.

Further, history also shows that the firm makes stock purchases. The new plan consists of replacing the existing $17 billion program.

Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends, according to John Burr Williams.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model). With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

Let´s estimate the inputs for modeling:

Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stockj = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: β =1.19

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rHD = RF + βHD [GGM ERP]

= 4.9% + 1.19 [11.43%]

= 18.50%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE=(Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Let´s collect the information we need to get the dividend growth rate:

Financial Data (USD $ in millions) Feb 2, 2014 Feb 3, 2013 Jan 29, 2012
Cash dividends declared 2,243,000 1,743,000 1,632,000
Net income applicable to common shares 5,385,000 4,535,000 3,883,000
Net sales 78,812,000 74,754,000 70,395,000
Total assets 40,518,000 41,084,000 40,518,000
Total Shareholders' equity 12,522,000 17,777,000 1,789,800
Ratios   Â
Retention rate 1 0.62 0.58
Profit margin 0.07 0.06 0.06
Asset turnover 1.95 1.82 1.74
Financial leverage 2.67 4.20 22.03
   Â
Retention rate = (Net Income – Cash dividends declared) ÷ Net Income = 0.58
   Â
Profit margin = Net Income ÷ Net sales = 0.07 Â Â
   Â
Asset turnover = Net sales ÷ Total assets = 1.95 Â Â
   Â
Financial leverage = Total assets ÷ Total Shareholders' equity = 3.24 Â
   Â
Averages   Â
Retention rate 0.59 Â Â
Profit margin 0.06 Â Â
Asset turnover 1.83 Â Â
Financial leverage 9.63 Â Â
   Â
g = Retention rate × Profit margin × Asset turnover × Financial leverage Â
   Â
Dividend growth rate 64.31% Â Â
   Â

Because, for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage until it reverts to the long-run rate – a smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($106.07 ×18.50% – $2.36) ÷ ($106.07 + $2.36) = 16.14%.

The growth rates are:

Year Value g(t)
1 g(1) 64.31%
2 g(2) 52.27%
3 g(3) 40.22%
4 g(4) 28.18%
5 g(5) 16.14%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Year Value Cash Flow Present value
0 Div 0 2.36 Â
1 Div 1 3.88 3.27
2 Div 2 5.90 4.20
3 Div 3 8.28 4.98
4 Div 4 10.61 5.38
5 Div 5 12.33 5.27
5 Terminal Value 606.22 259.42
Intrinsic value   282.53
Current share price   116.07

Final comment

We have covered just one valuation method, and investors should not rely on one alone in order to determine a fair (over/under) value for a potential investment.

Trading nearly the 52-week high seems to be announcing a fall in price. Its price is almost 60% smaller than its intrinsic value, so we can say that the stock is undervalued and subject to a potential buy.

Hedge fund guru Louis Moore Bacon (Trades, Portfolio) bought the stock, while Stanley Druckenmiller (Trades, Portfolio), Steven Cohen (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and the funds Pioneer Investments (Trades, Portfolio) and Manning & Napier Advisors, Inc. have added the stock in the last quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned.


[1] These values were obtained from Bloomberg´s CRP function.