Running head: Valuation of Home Depot
Valuation of Home Depot
Final Project Report
Christine Lee
David Stolper
Jieyoung Bang
FINA 4241 Corporate Financing Decisions
Tracy Yue Wang
Dec. 9th, 2008
Valuation of Home Depot
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Estimating Sales Growth Rate:
We have estimated sales growth for Home Depot at -2% for 2008 and 2009 and 4%
for the subsequent four year 2010 -2013. We took a conservative approach to estimating sales
growth. We understand the current economic conditions are extremely unfavorable,
particularly for the home improvement retail business and Home Depot. In 2006 and 2007
Home Depot was already reporting decreased sales at 2.16 and 2.04 percent respectively.
During this two time period the S&P 500 index increased approximately 16% before
beginning its steep downward slide in October 2007 (Google Finance). Also, during this
same time period, beginning 2006 and ending 2007, the Dow Jones U.S. Home Improvement
Retailers Index and the stock of Home Depot experienced a decreased of approximately 35%
(Google Finance).
We believe this downward trend in sales starting in 2006 was marking the beginning
of the mortgage crisis, and the beginning of the current financial crisis. Since the start of 2008
the S&P has dropped approximately 40% to date, while Home Improvement Retailers Index
and Home Depot’s stock has only dropped about 3%. While both indexes, as well Home
Depot are currently down approximately 40%, the Home Improvement Retailers index and
Home Depot lost the majority of their value in 2007 (Google Finance). What this shows is
that there has been a downward trend in the housing industry since 2006. The more gradual
decline in the housing industry preceded the steep downward movement in the general
economy. We feel the rebound of the housing industry is necessary and will precede the
rebound in the general economy, but that this will not happen until 2010. For this reason we
have projected decreased sales growth, in 2008 and 2009, for Home Depot consistent with the
decreased sales growth in 2006 and 2007. From 2010 to 2013 we expect positive revenue
growth; however, again we were conservative in our estimate and projected growth at 4% per
year for this time period.
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Valuation of Home Depot
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Finding Share Value Using After- Tax WACC Method:
Forecasting cash flows using this method required us to make several additional
assumptions: (1) we assumed total assets would be 20.3% of projected revenue for each year
2008-2013; and (2) we assumed total liabilities would be 15.7% of projected revenue for the
same time period. (3) We assumed the terminal growth rate for Home Depot to be constant at
4.6% per year; and (4) we assumed Home Depot will maintain a debt ratio of 25% for the
remainder of its business life. With a constant debt ratio the cost of debt and equity will
remain the same too. (5) We assumed Home Depot’s business risk will remain the same
throughout its life time.
We developed the first two assumptions using historical averages, calculating the
percentage of revenue accounted for by assets and liabilities for each year between 2003 and
2007 and then averaging the percentages (see reference cells H40 and H41). Using these
assumptions we forecasted working capital (see financials cells B138:G138) and then the
change in working capital (see financials cells B139:G139). We used historical averages to
forecast assets and liabilities because the standard deviation between years was very small;
meaning the ratio of assets to revenue and liabilities to revenue did not changing much from
year to year. This made us feel comfortable that the past asset and liabilities levels would
represent future levels will.
We forecasted the terminal sales growth rate by also using historical data from 20032007. The average growth rate for this time period was 4.6%. This rate is a conservative
estimate for future growth, which slightly outpaces inflation. In this case we justified using
the historic growth because Home Depot is a large mature firm meaning it should have
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predictable steady growth from year to year. Assumptions four and five are implied when
using the after-tax WACC method.
Estimating the equity value per share using the after-tax WACC approach yielded a
value of $17.91. This is fairly close to the average price, $22, of Home Depot stock for
November 2008; however, there are several factors that could explain the difference. First,
our estimates of revenue growth could be off. Most of our other forecasts are based off
revenue growth as percentages. Increasing the sales growth rates for 2008-2013, or increasing
the terminal growth rate will increase the net cash flows leading to a higher estimated value
per share. Also Home Depot’s debt ratio is higher then 25%, in theory, with no tax
consideration, the capital structure should not affect stock prices, however, when taxes affect
cash flow increased debt can shield profits from taxation increasing the overall cash flow of
the firm as well as increasing equity value (Brealey, 472).
Finding Share Value Using APV Method:
In using this method, our fundamental assumption was that debt ratio would remain
constant at 25% from 2008-2013 and after 2013. The same assumption we made when
calculating equity value using the after-tax WACC approach. We also assumed the cost of
financial distress was near zero. Although APV allows for a changing debt ratio we assumed
a constant ratio for simplicity. We felt it would be unlikely for Home Depot to change its dept
ratio in the short term because; it recently, in 2006 significantly increased its leverage.
Managers like to target a specific debt ratio and then stay near it (Brealey, 489).
Using the APV approach we predicted equity value at $29.22; this was significantly
different than what we predicted using the after-tax WACC approach. The APV approach
adds the PV of the future cash flows with the PV of the interest tax shield. In our calculations
the PV of the interest tax shield was approximately $18 billion. The tax shield is only
valuable, however, if Home Depot has profits to shield. In these current market conditions
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investors might be skeptical about Home Depots abilities to generate profits; hence, the value
of the interest tax shield might be perceived as lower by investors, resulting in equity value
lower than predicted by using the APV method. Also not accounting for the cost of financial
distress artificially inflates our projected equity value. For these two reasons we feel the after
tax WACC more accurately reflects the current value of Home Depot.
Changing the Debt Ratio of Home Depot:
Home Depot increased its leverage ratio because it felt the trade off between the gains
provided by the increased interest tax shield outweighed the increased risk of financial
distress. According to the MM theory, the capital structure of Home Depot will not have an
affect on its stock price because the return on Home Depot’s assets will remain the same
regardless of how they are financed (Brealey, 452). In the real world, though, taxes impact
financing decisions. In the case of Home Depot it is a large company with lots of tangible
assets. The Trade-Off Theory of Capital Structure predicts Home Depot should have a
relatively high debt ratio (Brealey, 488). In both these examples the cost of financial distress
was not figured into our calculations. Home Depot is a very large firm so we would expect it
to have a relatively low cost of financial distress. With the current market conditions,
however, it is possible that investors are discounting Home Depot’s stock price to account for
general increase in market risk. In any event, not including the cost of financial distress into
our calculations inflates the advantages of increased leverage. We think it was a good idea
for Home depot to increase its leverage in 2006. In our example doubling the debt ratio, from
25% to50%, increases the stock price from $17.91 to $23.09 and decreasing the debt ratio by
half, from 25% to 12.5%, slightly decreased the stock price from $17.91 to $17.81.This is
consistent with what we would expect to see. Increasing leverage will increase cash flow if
Home Depot has profits to shield.
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Valuation of Home Depot
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References
Brealey, Richard A. and Stewart C. Myers, and Franklin Allen. Principles of Corporate
Finance 8th ed. New York: McGraw-Hill Companies Inc. 2006.
Google Finance. Dow Jones U.S. Home Improvement Retailers Index. 08 Dec 2008
<http://finance.google.com/finance?q=I%3Adjushi>
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