DECEMBER 2002

Home (Depot) For The Holidays -- Session #3

Stock Studies & Case Studies

by Mark Robertson, Senior Contributing Editor

Home Depot (NYSE:HD) is ranked #5 in the Better Investing Top 100 for 2001. The company has also been at the top of the NAIC Most Active leader board since mid-2002. Home Depot was featured as the Undervalued Stock in the December 2002 issue of Better Investing. Participants are encouraged to read (or re-read) the undervalued feature. We may use this summary of the company as the study progresses. It sure seems like a fitting time to head Home (Depot) for the Holidays and complete a Stock Selection Guide (SSG).

Over the next few days, we'll take a look at Home Depot and complete an SSG. If you're just getting started and want to better understand the important influences on a Stock Selection Guide, I'll try to help. I'll share some of my favorite sources for research and apply them to development of the stock study. Normally, I'd start with an assessment of quality and a cursory look at Projected Annual Return (PAR), but we're going to save that for last in this case. The company's position in both the Top 100 and NAIC Most Active charts suggests that scores of NAIC investors have regarded Home Depot as a quality company with promising expected returns.

Questions? Ask them on I-Club-List. If you're a little bashful and still have a question, send an email to markr@better-investing.org.

Session #1 focused on the finding the facts and developed a sales growth forecast. Session #2 completed the Visual Analysis and Management Evaluation. This session will develop a Projected Annual Return forecast for the company. We'll wrap things up with Session #4, demonstrating the calculation of a quality rating for Home Depot and taking a closer look at judgments made and the results.

From Bent Railroad Tracks to 'Railing' About Returns

Let's start Session #3 by recapping where we've been. We've decided that Home Depot looks pretty good on the growth graph paper. It ain't perfect, and the bends cause us to lose a little sleep. Despite an SSG that originally slated growth at 23.5 percent, a revised SSG that accounted for recent history that suggested 19.0 percent, and an analyst that suggested 16.8 percent, we chose a forward-looking sales growth rate of 14 percent.

We extended the EPS trends to suggest that earnings per share (EPS) of $3.74 seemed feasible in 5 years. It did, however, seem pretty ambitious. We promised to take a closer look at this. We will. We also checked the management report card and found that profitability, whether measured as return-on-sales (2A) or return-on-equity (2B) compared pretty favorably to a solid competitor named Lowe's and the rest of the field.

Sections 1 and 2 of an SSG are an expedition seeking the answer to the question, "Quality Company?" Based on what we've seen so far, the answer is "Yes".

But Is HD On Sale?

After filling in prices, dividends and doing a few calculations, Section 3 of the SSG should look like this:

Click to enlarge.

We examine Section 3 to study the relationship between price and earnings, known as a P/E ratio. We want a better understanding of "What's normal?" for Home Depot P/E ratios. Prices fluctuate. So do earnings (EPS). Therefore, P/E ratios really fluctuate. In some cases, P/E ratios behave so badly that we have no choice to ignore them. You've seen children in grocery store aisles throwing tantrums? Sometimes the best medicine is to look the other way. It ain't easy.

We know that tantrums and exuberance both eventually pass. Over the long run, sales drive earnings. Earnings drive price.

The P/E ratios for Home Depot reached the stratosphere for 2 or 3 of the last five years. If we try to ignore the first three years, we might be able to get a better look at reasonable high and low P/E ratios for the company. This is illustrated in the accompanying graphic. It's time to select our expected high P/E ratio for Section 4A. So the choices are (a) 53.3x - Nothing ignored. (b) 37.5 - Ignore the highest levels. or (c) None of the above.

My choice is (d) Something influenced by the Value Line company report, so long as it seems to reflect any changes in growth rates for Home Depot.

Click to enlarge.

By looking back more than five years, we see that Home Depot's Average Annual P/E Ratio has ranged from 26.5x to 46.6x. The 4-year forecast slates the expected average annual P/E ratio closer to 28.0x. If we simply take the average of the high and lows after removing outliers, we observe an average P/E ratio of 28.5x. So, I'm a little bit more comfortable with (b) than I was. For many companies, they won't be this close.

I will often take the VL 4-year forecast P/E and divide it by three. In this case, it would be roughly 28/3 = 9.0. I'd consider using (28.0+9.0) = 37.0x for the High P/E... and (28.0-9.0) = 19.0x for the low P/E ratio in Section 4B.

Home Depot's growth rates are slowing. Although the company quality is steady, a slowing of growth rates necessarily should bring an expected reduction in P/E ratios.

We'll finish the selection of high and low P/E ratios tomorrow. For now, we just need the average P/E ratio in order to jump Section 4 and generate a Projected Annual Return (PAR).

We'll use an expected average annual P/E ratio of 28.5x, for now.

Expected Income, A Statement

We've accumulated most of the pieces that we need for a PAR calculation. We need an expected average price, a current price and an expected dividend yield.

The expected average price is the product of (1) an expected average P/E ratio and (2) expected EPS in 5 years. The current price is the price at which Dan Hess is willing to part with some of his shares. (Grin) People are reaching agreement today that Home Depot should change hands for $27/share. (Hint: Dan would want more than $27.)

But we said we weren't wild and crazy about $3.74 for our future EPS yesterday, didn't we? That we did. It's time to build an expectation that we can get a little wild about, if for no other reason that we built it ourselves.

All we need is (1) A current value for annual sales, (2) our 14 percent sales growth rate, (3) a forecast for expected net margin, and (4) a stab at an expected value for shares outstanding in the future.

Expected Annual Sales

We'll use $61,200 million, Value Line's estimate for year-end 2002 -- and take note that Jim Bond has already shot some holes in their estimate. The sales forecast for 5-years from now is determined using $61,200 and our selected 14 percent sales growth rate. At this growth rate, Home Depot sales will reach approximately $118,000 million in five years.

Expected Net Margin

From Value Line's 3-5 (4-year) forecast, we see that Carrie expects the Net Profit Margin to be 6.5 percent in 2006, plus or minus a year. Checking the last ten years or so, the highest that Percent Net Margin has ever been is 6.0 percent, maybe reaching 6.1 percent in 2002. (The jury's still out for a couple more months.) I'm going to use 6.0 percent for expected net margin. If the gang at Lowe's gets frisky, even 6.0 percent may prove ambitious.

Expected Outstanding Shares

Carrie has budgeted 2355 million shares for 2006, plus or minus a year. That might be a little lean and we choose based on how we feel about the trend for the last 5-10 years. For now, 2355 works for me.

The calculation, as shown in the accompanying table, is actually a series of three calculations. (I'm skipping our "secret pre-tax margin handshake" because taxes are relatively constant and preferred dividends because there aren't any. Under these conditions, our "preferred procedure" boils down to this.)

At a sales growth rate of 14 percent, $61,200 will become approximately $118,000 in five years. With a net profit margin of 6.0 percent, net income on that $118,000 will be $7,070 -- approximately $7 billion. With 2355 million shares, our EPS forecast becomes $3.00.

I feel much better about $3.00 in EPS (as I try to remain conservative, calm and collected, while heading back to Home Depot to buy yet another string of Christmas lights.) I'll be using $3.00 in Section 4A tomorrow.

The First Kousin of The Kahuna Calculation

The Kahuna, the Section 4A calculation, is the heart of an SSG. But the components of PAR are closely related and certainly another key organ. In this case, we have an expected average P/E ratio of 28.5x. Multiplying that by our $3.00 in EPS expectations nets a 5-year average price forecast of $85.50. As shown in the accompanying calculation: Present Value = $27.00, Future Value = $85.50 and Number of Years = 5.0. The annualized price appreciation is 25.9 percent.

The expected dividend yield for Home Depot, according to Carrie, is 0.3 percent. Combining the annualized price appreciation of 25.9 percent with the dividend yield of 0.3 percent delivers a projected average return (PAR) of 26.2 percent.

Continue to Session #4 - Quality and Conclusions

Return to Session #1 - Building A Sales Growth Forecast

Return to Session #2 - Meting and Meeting Management

This presentation is not intended as an investment recommendation on any company mentioned herein, but rather to serve as an example of how investors are using NAIC stock study methods. Neither NAIC nor the presenter of this material make recommendations with respect to the purchase or sale of securities. You are urged to make your own decisions based on your own investigations and analysis.