Valuation and Analysis of
Home Depot Inc.
Gracie Quintana
Jeff Miller
Christine Kyrish
Steven Poon
December 6, 2004
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Table of Contents
Financial Data Snapshot
1
I. Overview of Valuation
1
II. Business Summary
4
Products and Services
4
Competitors
6
Industry Analysis
9
Competitive Strategy
15
III. Accounting Analysis
16
Accounting Policies
16
Degree of Accounting Flexibility
19
Accounting Strategy
20
Quality of Disclosure
23
Quantitative Analysis
23
Red Flags
24
IV. Ratio Analysis and Forecasts
26
Ratio Analysis Section
27
Financial Statement Forecasting Methodology
29
Conclusion
33
V. Valuation
34
Cost of Capital
35
Method of Comparables
36
2
Discounted Dividends
37
Discounted Free Cash Flows
38
Discounted Residual Income
39
Long Run Average Residual Income
39
Abnormal Earnings Growth
40
Altman’s Z-score
41
Results
41
VI. Analyst Recommendation
42
VII. References
43
VIII. Appendix
44
Industry Graphs
44
Ratio Analysis
45
Competitor Annual Financials
47
Quarterly Financials and Forecasts
49
Annual Financials and Forecasts
52
Calculations used in Valuations
55
Method of Comparables Valuation
56
Discounted Free Cash Flow and Sensitivity Analysis Valuation
57
Discounted Dividends and Sensitivity Analysis Valuation
58
Residual Income and Sensitivity Analysis Valuation
59
Abnormal Earnings Growth and Sensitivity Analysis Valuation
60
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Investment recommendation: Home Depot is slightly overvalued therefore we
recommend it as a hold. The stock is poised to perform at least as well as the
market.
•
Home Depot is expected to penetrate foreign markets; this growth opportunity
will increase market share and the bottom line.
•
Uncertainty in the economy affects Home Depot’s sales, as it operates in a
cyclical industry. This uncertainty will not have a detrimental impact on the long
term growth of Home Depot and its subsidiaries.
I. Overview of Valuation
Company and Industry Overview
The Home Depot, Inc. is the world’s largest home improvement retailer and the
second largest retailer in the United States, earning $64.8 billion in revenues during the
2003 fiscal year. Operating under the cost leader strategy Home Depot derives its key
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success factors based on a tight-cost control system, stability of sourcing channels, and a
growth strategy based on core competencies. Home Depot’s growth strategy permits
further market penetration by enhancing a value chain of lower priced premium products
and the expansion of new store formats to support growing market trends. The successful
integration of distribution centers that lower transaction costs, an expansive product
selection through exclusive and proprietary agreements, and the initiation of a quality
assurance program positioned Home Depot to earn consistent above-average profits
within a highly fragmented retail (home improvement) industry.
Accounting Analysis
The accounting policies adopted by the Home Depot prove to be in line with it’s
business strategy. Overall, the Home Depot is very forthcoming with their accounting
practices and policies. The specifically identify three major areas of accounting policy in
regards to their specific industry to further their business strategy as it relates to
merchandise inventories, self insurance and revenue recognition. The firm is proactive in
divulging accounting policy regarding each of these areas. They specifically address the
firm’s actions in regards to required GAAP changes and liberally discuss their adoption
of certain GAAP in their financial reporting such as their policy regarding the upcoming
change in policy for the firm in their treatment of operational leases as opposed to capital
leases. The firm goes as far as to forecast how the change in policy will affect future
financial statements in 2004 the notes to their 2003 financial documents.
Ratio Analysis
Computation of the ratios relevant to the home improvement retail industry shows
no significant problems for Home Depot. Home Depot is operating on relatively wide
margins compared to its competitors. Costs have been managed well and debts are being
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paid more slowly; this does not pose a problem because the average payment time for the
industry is much slower than Home Depot. The sustainable growth rate is quite high
compared to Lowe’s which can be explained by Home Depot’s innovative business
strategy.
Forecasting
Sales growth over the past five years has grown fairly consistently. The growth
rate in sales is assumed to continue into the future, with a similar upward trend in future
earnings. Recently, Home Depot has taken on more short term debt, but this should not
impact their capital structure significantly. Total assets have been steadily increased over
the past five years and that trend is expected to continue. There is not a large spread
between the operating cash flow and earnings, which is a good sign for the quality of
accounting information. The growth trend in assets and income and cash flow can be
expected to increase because of expansion into other countries, mainly China and
Mexico.
Valuation
Different methods of valuation were used to assess the value of Home Depot. We
have the most faith in the abnormal earnings growth, residual income, and discounted
cash flow valuation methods. In the abnormal earnings and residual income model, the
stock was overvalued. In the discounted cash flow method the stock was slightly
undervalued. In the method of comparables valuations, the stock was most accurately
priced by the P/E method. If modest growth rates are assumed, along with a beta slightly
above the market’s beta, Home Depot’s stock is slightly overvalued.
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II. Business Summary
The Home Depot, Inc. is the world’s largest home improvement retailer and the
second largest retailer in the United States. Home Depot distinguishes itself as the leader
of the retail (home improvement) industry by focusing on sales, service, and execution.
By utilizing this operating strategy Home Depot reported a sales growth of 11.3% during
the 2003 fiscal year earning $64.8 billion in revenues, up from $58.2 billion in 2002.
The Home Depot, Inc. has set itself apart from industry competitors by
implementing a growth strategy of strengthening its core competencies by offering every
customer a unique experience through store modernization, carrying a variety of
distinctive merchandise, providing high quality service associates, and expert information
technology. Subsidiaries of Home Depot, Inc. provide specialized services to both the
individual homeowner as well as the professional customer.
Home Depot has a competitive advantage over other firms in the industry by
creating a dimension of tight cost control and providing premium value to customers
through merchandise selection and expert service. Home Depot is currently operating
1,778 stores in the United States, Canada, and Mexico. The Home Depot, Inc. is in a
highly competitive industry that is based on the factors of price, store location, customer
service, and depth of merchandise. Home Depot estimates that its share of the U.S. home
improvement industry is approximately 11 percent. Globally the home improvement
industry is approximately at $900 billion offering extraordinary growth opportunities.
The Company experienced an increase in comparable store sales of 3.8% in fiscal 2003
with an average ticket of $51.15, the highest in company history. The lawn and garden
category was the biggest driver in fiscal 2003 for the boost in store sales. This increase in
comparable lawn and garden sales can be tied to firm rivalry in the Southern United
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States, between Home Depot and Lowe’s, where a growing customer base and loyalty is
being won or lost as patrons have been affected by three hurricanes within thirty days of
each other.
Products and Services
Home Depot provides a blend of high-quality merchandise for all areas of home
improvement. In a highly competitive market Home Depot relies on competitive pricing
strategies, service-oriented associates, and supplying a combination of higher-end
premium products at a fair value. The Home Depot, Inc. provides specialized services to
the customer market through two main types of stores, Home Depot Stores and EXPO
Design Center Stores.
Home Depot Stores sell a wide range of building materials for home improvement,
lawn and garden products, and provide a number of valuable services. HD expanded a
number of in-store initiatives and programs to increase customer loyalty including:
•
Professional Business Customer Initiative: The Company increased the available
quantities of products typically purchased by professionals in bulk to provide
additional savings to the customer. HD has successfully anchored a position as a
cost leader through this initiative of a tight cost control system and low-cost
distribution.
•
Color Solutions Center: HD provides leading paint brands and proprietary paint
matching technology.
•
Appliance Sales: HD provides customers with unique premium appliances
manufactured by General Electric, Maytag, and other leading manufactures as
well as displaying and stocking the more popular appliances in the store.
•
Designplace Initiative: Offering an enhanced shopping experience to design
customers HD highlights its core competencies with superior product variety and
customer service. HD provides personalized service, specially-trained associates,
and an expansive merchandise selection.
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Tool Rental Centers: HD rents approximately 225 commercial-quality tools in 12
categories, including saws, floor sanders, generators, gas powered lawn
equipment, and plumbing tools to satisfy a broad range of the needs of
professional and do it yourself customers. This initiative allows HD to operate
under a tight cost control system and emphasize a key success factor of high
quality merchandise.
EXPO Design Center Stores offer interior design products, such as kitchen and
bathroom cabinetry, soft and hard flooring, appliances, window treatments, lighting
fixtures, and arrange installation services through qualified independent contractors. The
EXPO Design Center Store focuses on distinguishing itself from other industry
competitors by providing a strong value chain network of premium products and
accentuating core competencies within the business segment.
Competitors
With few direct competitors found within the highly fragmented home
improvement industry, Home Depot has differentiated its stores by offering several
unique formats to accommodate the needs and interests of customers while offering
products at a cost lower than the premium price customers are willing to pay. Of the
1,788 stores The Home Depot, Inc. was operating at the end of the second-quarter of
fiscal 2004 1,569 are Home Depot stores, 54 are Expo Design Centers, 11 Home Depot
Landscape Supply SM, 5 Home Depot Supply SM, and 2 Home Depot Floor Stores. For
this reason The Home Depot, Inc. has pitted itself against competition outside of its
immediate industry, retail (home improvement), and increased the high threat of
substitute products.
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Lowe’s Companies, Inc. (LOW) is the second largest retailer of home
improvement products in the world with $33.9 billion in revenue for the 2003 fiscal year.
With low switching costs to customers Lowe’s is Home Depot’s main rival within the
industry. Lowe’s serves and specializes in the do-it-yourself (DIY) customers,
appliances, lawn and garden, home décor, repair/remodeling, specialty trade contractor,
and property management market segments of the home improvement industry. Lowe’s,
as of January 31, 2003, operated 854 stores in 44 states with approximately 94.7 million
square feet of retail selling space. The company is operating under an aggressive growth
strategy focusing much of its future expansion on metro-markets with populations of
500,000 or more.
Lowe’s home improvement warehouse carries over 40,000 products and each
store provides a wide selection of nationally advertised brand name merchandise. Of the
thousands of items offered, both in the store and available through its special orders
system, Lowe’s merchandise selection supplies both the do-it-yourself (DIY) customer
and the commercial business customer with products and merchandise needed to repair,
maintenance, and complete construction projects. Lowe’s sources its products through
7,000 vendors worldwide, with no single vendor accounting for more than 4% of the total
purchases. The company is not dependent on a single vendor and has alternative
competitive distribution access available from suppliers to further increase its
opportunities for product quality and gross margin. The company has a strategic alliance
with HGTV network that allows it to exclusively run commercials for a substantial
portion of the commercial airtime. This is only one of a half dozen media partnership
programs employed to build the image and equity of the Lowe’s brand.
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Sherwin-Williams Company (SHW) generated $5.4 billion in revenue for the
fiscal year ending December 31, 2003 by engaging in the manufacturing, distribution,
and sale of coatings and related products to professional, industrial, commercial and retail
customers primarily in North and South America. The company relies heavily on
trademarks and trade name recognition, which significantly supplement the sales. The
Paint Stores Segment manufactures original equipment manufacturer (OEM) product
finishes. Original equipment manufacturer product finishes are sold to certain shared or
dedicated paint stores and by direct outside sales representatives building strong and
exclusive relationships with both buyers and suppliers of paint. The company is a
leading manufacturer and retailer of paints, coatings and related products to professional,
industrial, commercial and retail customers. Sherwin-Williams has a competitive
advantage over EXPO Design Centers by sustaining their industry position as the leading
manufacturer and retailer of paints. The sustainability of competitive advantage is
volatile depending on both product offered and market.
Tractor Supply Company (TSCO) is focused on supplying products for the
lifestyle needs of the recreational farmers and ranchers as well as tradesmen and small
businesses. The Company has identified a specialized market niche and focuses its
product mix on these core customers. The Company utilizes an “everyday low price”
strategy and offers exclusive top quality private label products to sustain a strategic
advantage over general merchandise, home center, and other specialty stores. Tractor
Supply Co. created a uniform store layout to provide maximum sales and operating
efficiencies. The company believes that is has differentiated itself by from “big box”
retailers by focusing on the specific needs of a target customer base. By utilizing this
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strategy TSCO has strengthened its value chain in comparison to Home Depot’s lawn and
garden segment.
Building Materials Holding Corporation (BHMC) is one of the largest
residential construction service companies in the United States with sales in excess of $1
billion. The Company specializes in providing construction services, manufactured
building components, and high quality materials to residential builders and contractors.
By targeting professional builders and contractors BHMC has positioned itself to gain
high-volume repeat customers. Building Materials Holding Corp. operates by
concentrating on manufacturing and installation services, on-time job-site delivery, and
volume purchasing which are not typically offered at smaller consumer-oriented retailers
but will become important to sustain a competitive advantage as the “baby boomer”
generation moves into the do-it-for-me (DIFM) segment of the market.
Griffin Land & Nurseries Incorporated (GRIF) is operated by its wholly owned
subsidiary, Imperial Nurseries, Inc. The landscape nursery business is extremely
fragmented, and the Company believes that its sales volume places it among the 20
largest landscape nursery growers in the industry. Imperial is currently reviewing a
number of ways to increase return on assets for its growing operations such as an increase
in the percentage of its product sold to retail garden centers. Sales to garden centers
generally have more favorable gross margins than those from sales of mass
merchandisers. The Company’s growing operations have been effected by seasonality
and increased shipping costs through distribution channels.
Industry Analysis
The retail (home improvement) industry is highly fragmented and has few direct
competitors for The Home Depot Inc. The Home Depot, Inc. and Lowe’s Companies,
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Inc. dominate the industry, controlling more than 30% of the U.S. market; Lowe’s, to
date, remains Home Depot’s single direct competitor within the industry. Home Depot,
Inc. has several store formats to compete in this highly fragmented industry, the store
formats include the traditional Home Depot store, EXPO Design Center store, The Home
Depot Supply store, Home Depot Landscape Supply, and The Home Depot Floor Store.
The estimated market share holding for Home Depot in the home improvement industry
is 11% at end of fiscal year 2003 but because of the fragmented industry measuring the
effect of sales against competitors is extremely difficult. The “Five Forces Model”
associates the intensity of competition and determines the potential for creating abnormal
profits by the firms within the industry.
Rivalry Among Existing Firms
The retail (home improvement) industry has an extraordinary opportunity for
growth globally. Viewed as once a stagnant market Home Depot has estimated the
global home improvement industry to be approximately $900 billion with enormous
potential for abnormal profits. Home Depot, Inc. is capitalizing on this by operating 102
Home Depot stores in eight Canadian provinces and 18 Home Depot stores in Mexico.
To increase customer base and service levels Home Depot often opens new stores near
the edge of market areas currently served by existing stores. This operating strategy,
known as ‘cannibalization,’ initially has a negative impact on store sales but provides for
long-run profitability by increasing customer service levels, gaining incremental sales,
and enhancing long-term market penetration.
The retail (home improvement) industry is highly concentrated with few publicly
traded direct competitors. Home Depot defines itself through an operating strategy based
on core competencies, premium merchandise, and lower costs.
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Threat of New Entrants
The Home Depot, Inc. offers product category leadership by offering high-end
appliances through exclusive agreements with manufacturers, superior quality service by
providing free how-to clinics, kiosks enabling customers to identify projects and print
step-by-step instructions in the store, and remains a cost leader through tight cost control
by offering tool rental centers to customers which offer 225 commercial-quality tool in
12 categories.
Most of the premium merchandise offered in Home Depot is purchased directly
through the manufacturer. Home Depot has formed strategic alliances and exclusive
relationships with a number of suppliers to market products giving Home Depot an
absolute cost advantage over new entrants. Home depot is dependent upon the timely
execution and delivery of products to its stores to maintain an inventory of competitively
priced premium products. To compete nationally Home Depot has built central
distribution centers to process globally sourced merchandise more efficiently. Transit
facilities have effectively lowered the number of distribution centers required in the
United States and Canada. Home Depot utilizes 10 transit facilities in the United States.
It is here that Home Depot receives and processes merchandise from manufacturers and
then immediately cross-docks it onto trucks for delivery to specific stores.
Approximately 40% of the merchandise shipped to the stores was processed through the
network of distribution centers and transit facilities with the intent of lowering
distribution costs and increasing seamless efficiencies for the end-consumer.
Threat of Substitute Products
Customers’ willingness to switch is often the critical factor in making the
competitive dynamic work. Home Depot maintains a global merchandise program to
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source high-quality products directly from overseas manufacturers, which gives the
customers an expansive selection of innovative products and better value, while
enhancing gross margin. Outside, smaller, retailers have the ability to target a specific
need and interest of the consumer and to provide dedicated service and knowledge to an
individual customer. Strategic alliances from manufacturers for exclusive product
distribution in dedicated home improvement stores, such as Sherwin-Williams with
Dutch Boy paint, curtails the mass utilization of Home Depot’s paint mixing stations,
which represent an integral part of the store modernization. The Company offers a
variety of installation services expanding its market share based on the uniqueness of the
Home Depot’s core competencies and value chain.
Home Depot has recognized an opportunity for increased market share by
examining “mega trends” in the growth of the Hispanic population and the aging
population. Eighty-five percent of the nation’s homes were built prior to 1980 and will
be in need of frequent repair heightening the future opportunity of the “do it for me”
sector of Home Depot customers. Services provided by Home Depot include the
installation of carpeting, hard flooring, cabinets, water heaters, and solid surface
countertops through qualified independent contractors in the U.S. and Canada, lending
itself out as a unique service provider to the consumer.
Bargaining Power of Buyers
Home Depot buys store merchandise from vendors located throughout the world
and is not dependent on any single vendor establishing the Company’s bargaining power,
relative to that of the supplier’s, high. Merchandise is bought directly through the
manufacturer and shipped to stores through transit facilities. Home Depot employs a
global sourcing merchandising program into its core strategy to source high-quality
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products directly from overseas manufacturers. Product development associates travel
internationally to identify opportunities to purchase items directly for Company stores
eliminating the “middleman” costs allowing Home Depot to develop a price sensitive
product selection for the consumer and increase the Company’s gross margin. HD has
established strategic alliances with certain suppliers to market products under a number
of proprietary and exclusive brands. Home Depot has two sourcing offices located in
Shanghai and Shenzhen, China, and has a product development merchant located in
Bonn, Germany. These assignments allow HD to advance product features and quality,
to import products not currently being offered to customers and furthers the operating
strategy of offering premium products at a lower cost than would be available through a
third-party vendor.
Bargaining Power of Suppliers
Home Depot’s suppliers are numerous with no supplier playing a major
contributory role critical to the Company’s business. HD currently source products from
more than 500 factories in approximately 40 countries. The Home Depot, Inc. has
initiated a quality assurance program to measure factors such as product quality, timely
shipments, and fill rate of all vendor performance. The quality assurance program has
established a strict standard to which product performance must adhere. Product testing
prior to purchase ensures the compliance of product requirements with HD specific
policies. Home Depot systematically evaluates product quality and factory performance
by conducting inspections at the factory to assure continued compliance with HD’s
product requirements.
The retail (home improvement) industry allows Home Depot to
maintain considerable power over vendors because of their large buying power and
relatively low switching costs.
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Competitive Strategy
The Home Depot, Inc. has positioned itself within the industry based on a strategy
of cost leadership. This operating strategy allows the Company to earn above-average
profitability by dictating prices from suppliers lowering input costs and minimizing
distribution transactions eliminating the “middleman.” HD has developed a tight-cost
control system through quality assurance program that monitors vendor compliance with
Home Depot requirements. Home Depot has positioned itself for future business by
generating distinctive store formats to accommodate a diversified customer base allowing
HD to compete in niche markets such as lawn and garden and the private contracting of
home installation. Home Depot’s core competencies are centered upon the timely
execution and delivery of products to its stores to consistently providing an inventory of
competitively priced premium products.
Achieving and Sustaining Competitive Advantage
Home Depot must find a viable way to introduce new business segments and
services into the company structure while maintaining the image of comparable highquality value merchandise and service. The sustainability of Home Depot’s competitive
advantage is based on the Company’s ability to control cost at the source while providing
superior product variety and customer service. Key success factors for The Home Depot,
Inc. are the stability of costs and availability of sourcing channels, lowering input costs
through monitoring of vendors, and concurrently escalating efficiency at all levels for the
end-consumer. Home Depot currently has both the resources and capabilities to maintain
these key success factors. Improved inventory management resulted in lower shrink
levels for imported products, and enhanced service associates contributed to an increase
in average ticket growth in every selling category, with an average of 8.2 percent, from
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$4.13, to $54.73, in the second quarter of fiscal 2003. Fluctuations in the U.S. economy,
the Company’s ability to retain highly qualified associates, unforeseeable and unusual
weather conditions, and the impact of competition remain deterrents to maintain a
profitable going-concern for The Home Depot, Inc. Home Depot’s value chain is
expanding to accommodate a balanced consortium of customers. The value chain
includes the introduction of paint centers, tool rental centers, trained associates, increases
in technology, and store modernization customizing formats to the needs of the market.
Applying The Cost Competitive Strategy
Home Depot has maintained a competitive strategy to date through the integration
of low transaction costs, premium quality merchandise, and specialized services to meet
the demand of growing niche markets. HD has developed a growth strategy anchored in
continuously assessing opportunities to increase customer loyalty, increase sales, and
further market penetration. The Home Depot, Inc. grew service revenues by
approximately 27 percent to $883 million in fiscal 2003. In fiscal year 2003, HD acquired
White Cap Construction Supply, Inc., to operate 74 Pro distribution branches across the
country. Home Depot’s strategy remains strengthening its core competencies through
quality assurance and consistent competitive prices. Expansion of tool rental centers to
925 stores in the United States, the purchase of 20 Home Mart stores in Mexico, and the
operation of 1,788 stores in the U.S. are attributed to Home Depot’s key success factors
and competitive cost strategy.
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III. Accounting Analysis
The Home Depot, Inc. Accounting Policies
The retail industry, in general, presents a very competitive market with high price
competition and low product differentiation. Although almost any retailer, from
supermarkets to superstores, can offer home improvement items at a competitive price,
the home improvement industry currently provides a great opportunity for differentiation
in regards to the types of services home improvement retailers offer. To successfully
maximize sales and increase revenues in the home improvement industry, retailers such
as Home Depot must successfully combine product variety, quality and price and
specialized services. As discussed earlier, Home Depot has adopted a business strategy
based on these key factors. Consequently, as we look at Home Depot’s overall financial
results, it is necessary to focus on key accounting policies adopted by the company to
measure critical factors and risks.
In the “Management’s Discussion and Analysis of Results of Operations and
Financial Condition” of The Home Depot, Inc 2003 Annual Report
(www.homedepot.com), management identified three major areas as areas of critical
accounting policy and discussed the adoption of four different accounting
pronouncements. In addition to the four recently adopted accounting pronouncements
identified in the management’s discussion, The Home Depot identified four other major
accounting policy changes in it’s “Notes to Consolidated Financial Statements”.
Specifically, The Home Depot adopted four different accounting pronouncements in
regards to service revenue recognition, vendor allowances, goodwill amortization and
stock based compensation. The three critical accounting policies, as identified by The
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Home Depot management refer to the treatment of merchandise inventories, self
insurance and revenue recognition.
Merchandise Inventory policy is specifically addressed by The Home Depot
management in “Management’s Discussion and Analysis of Results of Operations and
Financial Condition” and is assessed in two different ways. Approximately 93% of total
inventory is valued at the lower of cost or market utilizing FIFO under the retail
inventory method with the other 7% valued under the cost method. The Notes section of
the Financial Statements accounts for the two different methods. According to the Notes,
the 7% of inventory valued under the cost method was due to inventory policy of certain
subsidiaries and distribution centers. In addition, The Home Depot, Inc. takes a physical
inventory count on a regular basis at each store to verify that inventory amounts in the
merchandise inventory section of the Consolidated Financial Statements are accurate.
Lastly, in regards to merchandise inventory, the company does account for possible
inventory shrinkage or swell based on historical results and industry trends.
Self Insurance accounting policy for Home Depot addresses it’s treatment of
“losses related to general liability, product liability, workers’ compensation and medical
claims”. The total liability is estimated on the total cost incurred as of the specific
balance sheet date and is not discounted. The estimate is based on “historical data and
actuarial estimates”. The company also explains in it’s Management Discussion that they
ensure estimates of liability are as accurate as possible by having both management and
third-party actuaries review the estimates on a quarterly basis.
Revenue Recognition is the third critical accounting policy identified by The
Home Depot management. Revenue recognition at the Home Depot follows the industry
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norm of recognizing revenue when the customer takes possession of the merchandise or,
if a customer makes payment prior to take ownership of the merchandise, Home Depot
records the sale as Deferred Revenue on the balance sheet until the sale is finalized when
the customer takes possession of the paid merchandise. Additionally, because The Home
Depot also provides a variety of services through their installation and home maintenance
programs, they also recognize service revenue at the time when the service is completed
and also record any customer pre-paid service revenue as Deferred Revenue on the
balance sheet.
Lastly, Home Depot management discusses four accounting pronouncements
dictated in 2003 that could possibly affect their 2003 Consolidated Financial Statements.
The first pronouncement, Staff Accounting Bulletin No. 104 (SAB 104)1, issued in
December 2003, addresses the SEC’s view on the treatment of revenue recognition in
accordance to GAAP. According to Management’s Discussion, this pronouncement had
no affect on their consolidated financial statements. The second pronouncement,
Statement of Financial Accounting Standards No. 150 (SFAS 150), “Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and Equity”2,
issued in May 2003, did not have any impact on the Home Depot’s 2003 Consolidated
Financial Statements according to Management’s discussion. The primary reason for the
lack of impact is because of SAFS 150’s effective date. SAFS 150 applies only to
instruments “entered into or modified after May 31, 2003” or “at the beginning of the
first interim period beginning after June 15, 2003.” The third accounting pronouncement
was issued in April 2003. Statement of Financial Accounting Standards No. 149
(SFAS 149), “Amendment of Statement 133 on Derivative Instruments and Hedging
21
Activities”3 again did not affect Home Depot’s 2003 Consolidated Financial Statements
because of it’s effective date. The amendment affect contracts entered into or modified
after June 30, 2003 and were integrated into the consolidated 2003 statements. The last
pronouncement, a revision the FASB’s Interpretation No. 464, requires Home Depot to
consolidate any variable interest entities “if a company’s variable interest absorbs a
majority of the entity’s losses or receives a majority of the entity’s expected residual
returns, or both”. The FASB requires any company falling into this situation to
consolidate the entity in the first reporting period that ended after March 15, 2004 and so
Home Depot committed to integrate the change in the first Quarter of 2004.
Home Depot does comment on almost all portions, assets (revenues), liabilities
(expenses) and owners’ equity, of their financial statements items relevant to accounting
policy for each line item. Most of their policy statements are detailed while other
portions are vague or generic in terms of applied numbers. However, The Home Depot
does disclose changes for most of their critical accounting policies in either the
Manager’s Discussion or in the Notes to Consolidated Financial Statements.
Degree of Accounting Flexibility
The Home Depot, Inc. has an average degree of flexibility, as do many in the
retail industry. For example, most retail companies have flexibility in selecting their
policy on inventory valuation. The Home Depot chose FIFO in comparison to LIFO, for
example, and combines both cost and retail methods in inventory valuation. A
comparison of Home Depot’s depreciation policy to those of similar retailers shows
consistency in the depreciation schedule of various fixed assets. Home Depot also has
an option on how to depreciate or amortize intangible assets, such as goodwill, and a
comparison to their largest competitor, Lowe’s Home Improvement, provides another
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example of differing accounting options and decisions. Oppositely, the company has
very little option in how they recognize revenue, either sales or service revenue, as
discussed under Management’s discussion; Home Depot was recognizing service revenue
at the time the service was completed prior to the issuance of SAB 104. Home Depot had
to, overall, address four different accounting pronouncements in 2003 limiting some of
their accounting flexibility.
Another aspect of The Home Depot’s accounting flexibility is evident within their
financial statement disclosures. A comparison of the Management’s Discussion of
Financial Results and Notes to Consolidated Financial Statements for The Home Depot
and Lowes Home Improvement yields much more data in The Home Depot’s documents.
Some general examples include The Home Depot’s disclosure of financial data in table
form comparing the last 2 years to the current 2003 statements and summarizing, within
the notes, the overall impact of the accounting policies, changes to specific accounts,
and/or changes to liabilities or estimates. In some cases, it specifically lists future
estimates and the impact of those estimates for the upcoming financial period (2004) as in
the notes regarding capitalization of interest expense on capitalized leases.
Accounting Strategy
Further analysis of key accounting policies and advantages and disadvantages can
help us better identify some of The Home Depot’s actual accounting strategy.
The use of FIFO vs. LIFO in inventory valuation can tell give us some information on
The Home Depot’s accounting strategy. We can only assume that FIFO is utilized by
The Home Depot because most inventories in the retail industry are a FIFO physical
flow. Secondly, although LIFO would lower taxable income, LIFO could be utilized to
manipulate net income (liquidation of older layers at historical costs could affect COGS
23
and consequently, net income). In the retail industry, FIFO more closely matches Just In
Time Inventory because of high inventory turnover in the industry overall. From an
operational management standpoint, FIFO also provides higher profits at higher price
levels. We assume from sections of Management’s discussion and from an industry
tendency, that bulk purchases of inventory usually involve discounts from manufacturers.
FIFO then allows the Home Depot to sell at a higher price to the consumer translating
into higher profit margins for the firm. Management’s Discussion partially attributes a
higher gross profit, an increase of 13.7%, to “Improved inventory management, which
resulted in lower shrink levels, increase penetration of import product, which typically
have a lower cost”. Overall, inventory management can have a dramatic impact on both
balance sheet and income statement results.
Other items that must be analyzed to help identify actual accounting strategy are
accounting pronouncements mentioned in the Notes section of the 2003 Consolidated
Financial Statements. Perhaps the most impacting of these pronouncements was EITF
02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration
Received from a Vendor”. EITF 02-16 states that “cash consideration received from a
vendor is presumed to be a reduction of the prices of the vendor’s products or services
and should, therefore, be characterized as a reduction in Cost of Merchandise Sold”.
According to the Manager’s Discussion, The Home Depot received consideration in the
form of advertising allowances. Prior to the adoption of EITF 02-16, this had the affect
of increasing intangible assets (prepaid advertising) and decreasing advertising expense.
In both 2001 and 2002, advertising allowances provided by vendors exceeded gross
advertising expense by 31 million and 30 million respectively and were recorded as
24
reductions in COGS. Again, this reduced expenses and maximized net sales, increasing
net profit. However, The Home Depot does disclose, in their 2003 Consolidated
Financial Statements, the affect of the change at the end of the 2003 fiscal reporting
period and estimated changes in COGS (decrease), the increase in operating expense
and the reduction in inventories on a Pro Forma table within the Manager’s Discussion.
Another actual accounting strategy can be analyzed in the treatment of Cost in Excess of
Fair Value of Net Assets Acquired. According to the Notes, The Home Depot stopped
amortizing goodwill effective February 2002 (under SFAS 142, “Goodwill and Other
Intangible Assets”). Accordingly, Home Depot recorded impairment charges of $0 in
2003, perhaps inflating assets on the balance sheet and deflating expenses on the income
statement. Yet another example of accounting strategy is The Home Depot’s policy
regarding capital leases. The company discloses in its Notes that it exercised its option
to purchase certain assets in December 2003 that were previously leased in an off-balance
sheet agreement with a special purpose entity. However, not until late in the financial
period does the company acquire the asset with a related expense for fair market value
and related depreciation expenses. One last item that should be mentioned is the
inclusion of assets from both the Canadian and Mexican subsidiaries. In comparison to
U.S. federal taxes, foreign taxes liability accounted for only 5% and 3% in 2003 and 2002
respectively while federal tax liability account for 82 % and 83% in 2003 and 2002
respectively.
Based on the analysis of these accounting strategies and changes in strategy in
2003, our assertion of The Home Depot’s actual accounting strategy would be that The
25
Home Depot practiced an aggressive accounting strategy where assets were maximized
and expenses were minimized.
Quality of Disclosure
Qualitative Analysis of The Home Depot’s disclosure should be discussed. It is
our opinion that there is more than adequate discussion of business strategy and risks in
The Home Depot’s 2003 Consolidated Financial Statements. Specifically, in the
Chairman’s Letter, Bob Nardelli, Chairman, President and CEO, summarizes the overall
fiscal year 2003 results and financial condition and well as key initiatives. Additionally,
there is sufficient detail disclosed on policy and changes in policy during 2003. Not only
is policy disclosed, the company goes a step further and discloses projections to account
for those changes as exemplified in their disclosure of the effect of EITF 02-16, the
changes in capitalized lease policy as well as financial projections of this change into the
first quarter of 2004 and in discussions such as the reasoning for an increases in SG&A
expenses. One shortfall, however, does exist in the quality of segment reporting,
which is almost non-existent and could be broken out into geographical segmentation,
to account for U.S. results versus Canadian and Mexican subsidiary results or into
product segmentation, given the listing of initiatives such as tool rental, flooring, proservices, appliance sales and lawn and garden sales.
Overall, we deem The Home
Depot to be forthcoming in their accounting policy and assess the quality as good to
excellent.
Quantitative Analysis of the Company’s accounting should also be addressed.
Because the Company is in the retail industry, and as asserted earlier, has to be measured
on items such as inventory, we will consider certain sales and expense diagnostics as
follows:
26
Potential “Red Flags”
The existence of a special purpose entity with regards to Capital Leasing options
for certain assets (distribution centers, warehouses, retail locations and office space) was
established for the purpose of leasing these assets “off the balance sheet”. As discussed
in the Notes to the 2003 Consolidated Financial Statements, the Company took their
option to purchase the assets and include the asset on the consolidated balance sheet for
fiscal year 2004. Once the option to buy the assets was made in December 2003, the
special entity was dissolved. All policy regarding this transaction as well as a discussion
27
of the impact of this decision are disclosed in the Notes to the 2003 Consolidated
Financial Statements.
Notes
1.
Revises or rescinds portions of the interpretative guidance included in Topic 13 of
the codification of staff accounting bulletins in order to make this interpretive guidance
consistent with current authoritative accounting and auditing guidance and SEC rules
and regulations. The principal revisions relate to the rescission of material no longer
necessary because of private sector developments in U.S. generally accepted accounting
principles. Also rescinds the Revenue Recognition in Financial Statements Frequently
Asked Questions and Answers document issued in conjunction with Topic 13. Selected
portions of that document have been incorporated into Topic 13. U.S. Securities and
Exchange Commission [on-line]. Selected Staff Accounting Bulletins: SAB 104;
available from http://www.sec.gov/interps/account.shtml; Internet; accessed 28
September 2004.
2.
This Statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and equity. It requires
that an issuer classify a financial instrument that is within its scope as a liability (or an
asset in some circumstances). Many of those instruments were previously classified as
equity. Some of the provisions of this Statement are consistent with the current definition
of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements.
Financial Accounting Standards Board [on-line]. FASB Pronouncements: Statements of
Financial Accounting Standards; Statement 150; available from
http://www.fasb.org/st/#fas150; Internet; accessed 28 September 2004.
3.
This Statement amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as derivatives) and for hedging activities under FASB
Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.
Financial Accounting Standards Board [on-line]. FASB Pronouncements: Statements of
Financial Accounting Standards; Statement 150; available from
http://www.fasb.org/st/#fas149; Internet; accessed 28 September 2004.
4.
This Interpretation of Accounting Research Bulletin No. 51, Consolidated
Financial Statements, addresses consolidation by business enterprises of variable interest
entities,* which have one or both of the following characteristics:
The equity investment at risk is not sufficient to permit the entity to finance its activities
without additional subordinated financial support from other parties, which is provided
through other interests that will absorb some or all of the expected losses of the entity.
1. The equity investors lack one or more of the following essential characteristics of
a controlling financial interest:
a. The direct or indirect ability to make decisions about the entity's activities
through voting rights or similar rights
28
b. The obligation to absorb the expected losses of the entity if they occur,
which makes it possible for the entity to finance its activities
c. The right to receive the expected residual returns of the entity if they
occur, which is the compensation for the risk of absorbing the expected
losses.
Financial Accounting Standards Board [on-line]. FASB Pronouncements: Summary of
Interpretation #46; available http://www.fasb.org/st/summary/finsum46.shtml; Internet;
accessed 28 September 2004.
IV. Ratio Analysis and Forecasts
Introductory Section:
Purpose of this section: The fundamentals behind Home Depot look good and
have proven profitable, but it is necessary to evaluate the company based on its actual
numbers and analyze that against the competition. It is possible to use analytical methods
to take into account business factors and outside factors that will affect the firm and
predict the economic effects on the firms financial statements. Methods employed in this
analysis include, time series analysis, cross-sectional analysis, ratio analysis, prospective
analysis, analysis by charts.
A general idea of the opportunities facing the firm and how well the firm has
already exploited its opportunities can be gained by doing this analysis. It is beneficial to
current and potential investors to see the potential performance of an investment in this
particular company.
Financial Ratio Analysis Section:
In this section, five years of annual data filed with the SEC have been used to
perform a ratio analysis of Home Depot and evaluate the company’s liquidity,
profitability, and capital structure. Specific ratios that are chosen for this industry outside
of the basic 14 are there because they represent a pertinent success factor for the business.
29
Ratio Analysis
Liquidity:
Home Depot appears to be a solid company after computing relevant
ratios. A few ratios indicated that there may be some change in capital structure and
operating efficiency. Overall, no significant problems exist.
Home Depot is not struggling to pay its debts to creditors. The quick ratio trends
upwards while, the ability to pay current debts has shown a downward trend. This trend
is not a cause for concern because some debt has been generated from expansion into the
Chinese and Mexican markets.
Because Home Depot collects payments (cash or other means of payment) at the
point of sale, the days’ receivables outstanding are low. Home Depot offers credit cards,
mainly to contractors and frequent shoppers; this is the main thing keeping the
receivables ratio from being even better. Another key ratio is the days’ supply of
inventory, being that Home Depot is a retailer. The days’ supply of inventory is fairly
stable (Days’ supply is currently 71.84) with a slight increase in last year’s data, not a
large enough increase to cause concern of obsolescence or impairment.
When compared to Lowe’s, Home Depot looks very similar in terms of liquidity.
Lowe’s collects is receivables a bit quicker and maintains a higher current ratio at 1.4, but
they hold quite a bit more inventory. Lowe’s is the main competitor of Home Depot and
it makes sense that their measures of liquidity would not stray too far from each other.
Profitability:
Both Home Depot, and Lowe’s are profitable companies that seem to have good
years together and decline together. The industry shows a trend to move upwards with
small increases in profitability.
Home Depot operates on a gross margin above 30% and
30
the net margin is nearly 7%. This margin is somewhat thin compared to other industries
but is wider than its competitors. The Home Depot is profitable because it generates
large amounts of sales and can take smaller profits on each sale.
One measure of profitability that did stand out concerned the operating expense
ratio. Lowe’s operating expense ratio has remained flat over the past five years and
Home Depot has gone up slightly. I do not believe this increase is significant or is a sign
of management problems. Selling, general and administrative expenses as a percent of
sales have increased slightly. The return on assets and return on equity ratio depicts that
Home Depot manages its assets better than Lowe’s and manages to generate a greater
return on assets and return for shareholders.
2004 ROE Breakdown
ROA = Net Income/Sales x Sales/Assets
4304/64816 x 64816/34437
0.664 x 1.8822
0.125
ROE = ROA x Assets/Equity
0.125 x 34437/22407
0.125 x 1.5369
0.1921
Capital Structure:
Compared to Lowe’s, Home Depot uses much less debt financing, whereas
Lowe’s uses over a third of debt financing. Both companies have the ability to make
good on their upcoming debts. In 2002 and 2003, Home Depot utilized more debt in
acquiring their basis in Mexico causing a surge in their debt to service ratio. Once
purchased, their service ratio decreased again to within an industry average in 2004.
31
Other Ratios:
Home Depot is paying their debts slower; this can be seen in the day’s payables
and turnover ratios. This does not seem problematic because in past years Home Depot
paid much quicker than Lowe’s, now their ratios are the same. NOPAT and EBITDA
margins were included to show any differences between Lowe’s and Home Depot in
terms of non cash expenses since EBITDA does not include depreciation or amortization.
NOPAT shows the company in light of operating policy and excludes debt policy. Both
these ratios for both companies are very similar and show that they operate similarly.
Other Ratios were included to show how Home Depot chooses to manage its long
term assets relative to Lowe’s. They are both retailers, neither holds much cash on hand
to cover any debts that may arise immediately, both have similar policies for long term
assets in turnover and asset use.
The sustainable growth rate for home depot at the year end of 2003 is 0.22
whereas the growth rate for Lowe’s is 0.19. The sustainable growth rate for Lowe’s has
consistently been lower than that of Home Depot for all years analyzed here. Home
Depot has shown strong growth in past years but that growth will probably slow down
below what is sustainable.
Financial Statement Forecasting Methodology Section
Method for forecasting Quarterly income statement:
Sales have been about 23% for Q1, 27% for Q2, and I have forecasted that sales
will continue to be 25% of annual sales for Q3, with the other 25% coming from Q4. I
assume slower growth than is predicted by past trends. The growth seems well above the
industry average and I still make the assumption that sales will grow at 11% indefinitely.
The sustainable growth rate suggests that the company can grow at nearly 20%. An
32
average company’s sales would be around 9% and Home Depot is an above average
company.
Cost of Goods Sold shows a slight decreasing trend in recent quarters. I would
expect to see a further decrease in costs to 67% of sales for the year. Costs are expected
to show a further decline in the future 10 years and I believe they will become stable at
65% of sales growing at a rate of 10%. Total Assets/Sales waver near the 2.0 mark, so I
make the assumption that total quarterly assets will be twice sales. A sporadic decline in
the growth of long term tangible assets can be observed; a level of 60% of total assets
will be assumed for tangibles at the beginning and end of the fiscal year; continuing to
fall to 55% in other months. There is a closer relationship and superior trend between
inventory/total assets than inventory/sales, therefore inventory will be maintained at 25%
of total assets and 1% higher for the beginning of the fiscal year as long as it continues to
reflect the current level of sales.
A trend has been established where more cash and marketable securities are held
late in the year and fewer in the beginning. A level of 13% of sales at the end of the year
and 9% of sales at the beginning are assumed, both numbers based on past data that will
continue. Long term intangibles show no sign of changing and are expected to remain
the same percentage of assets they are presently, 3.5%.
Method for forecasting quarterly Balance sheet:
The ratio of debt to equity has been stable for the past five years (approximately
0.06) I have no reason to believe this ratio will change. Home Depot has taken on more
short term debt than previous quarters but I do not believe this to have the ability to
significantly change the structure of Home Depot’s financing.
33
There is no specific quarterly trend in common shareholders equity except that it
shows slight infrequent decreases, equity will be assumed to remain at 58% of total
liabilities and shareholders equity for the remainder of the fiscal year. Short Term Debt
will remain unchanged for the next two quarters, as it has for the past year.
A trend that has been interesting is that Home Depot is making good on its
payables more slowly (days’ payables increasing). I don’t expect to see a significant
increase in payables over the next two quarters because Home Depot does not appear to
have a cash shortage, so the payables balance is left at 19% of total liabilities and equity.
Other current liabilities show a trend of remaining relatively flat over past years. Other
long term liabilities show a stronger upward trend than long term liabilities so a 7%
growth rate based on growth in past data will be assumed.
Method for forecasting annual Income Statement:
From the quarterly income statements it can be assumed an 11% growth in sales
and 10% growth rate for cost of goods sold will continue into the future. It is my
assumption that growth in cost of goods sold will decrease around 2009 to remain at
about 65% of sales. Selling, general and administrative expenses as percent of sales
tends to fluctuate around 20% of sales in quarterly, and annual data, I forecast it to
remain at 21% of sales. Other operating expenses are assumed to remain constant and
continue to be 90 million for forecasting purposes.
As stated in the notes to the financial statements, the effective tax rate is 37%.
This was used to calculate future tax expenses.
34
Method for forecasting annual Balance Sheet:
From my quarterly forecast I can say that assets for 2005 will be 39930, then for
subsequent years I will assume them to be 53% of sales. Because the fiscal year ends in
the middle of January and I forecasted the quarterly statements to end then I will transfer
the balance sheet values to year 2005 in the annual forecast.
Accounts Receivable tends to remain at about 3.5% of total assets in past data, see
no reason to forecast a change. For the annual forecast, I will assume that inventory is
14% of sales instead of using the common size data simply because the sales data seems
to more closely approximate the appropriate amount of inventory. Cash and Marketable
Securities are held at a 4% of sales. I calculated other current assets by working
backwards into them from an assumption that current assets make up a bit more than a
third (38%) of total assets. Long term tangible assets are 58% of total assets and
intangibles are 2.5% and are expected to be the same percentage in the future. I worked
backwards into other long term assets after calculating other values, since total assets
have already been calculated.
Short term debt shows a large increase this quarter. In management’s discussion
of results, management cites growth plan in areas such as the Floor store section of their
business and improvements in their existing stores in an effort to modernize some older
buildings. Our assumptions are that Home Depot assumed a larger short term debt to
finance these improvements. We expect this level of debt to normalize over the next year
as these improvements are short term investments in capital assets. Accounts payable
show faster growth relative to sales growth, this trend is expected increase to 13% by
0.5% per year and remain at this level. Total Current Liabilities show no specific trend as
a percent of total liabilities and equity or as a percent of sales (except that it is
35
increasing). Current Liability growth does seem to track growth in total current assets.
Current liabilities have grown faster than current assets, bringing the current ratio down
in the past where it is currently at 1.4. I will continue the trend into 2005 it is not my
belief that home depot will maintain the ratio here. It makes more sense to bring the ratio
closer to 1.5, where it will be in the long run. Long term debt is becoming a smaller and
smaller percentage of total sales and total liabilities and equity. I would not expect the
decreasing trend to continue any longer past 2005. Equity shows a consistent trend of
being 32% of sales and it is forecasted to continue.
Method for forecasting annual Cash Flows:
Home Depot hasn’t strayed too far in terms of performance on a cash basis
against performance on an accrual basis. This is a good sign for the quality of
accounting. We also assume that all balance sheet ratios will increase proportionately
with the sales growth rate. There aren’t any significant faults to be observed in the cash
flow of Home Depot, and future prospects for the firm look good as well. I calculated the
forecasted cash flow information by starting with a comparison of cash to sales. I then
took the data as a percent of sales for forecasting purposes.
Conclusion:
Home Depot appears to be a solid company that has recorded good performance
in past years. A prospective analysis of the company shows that future growth prospects
look good. Ratio analysis against the main competitor, Lowe’s, shows that Home Depot
is performing above the competition. Investors have rewarded Home Depot with better
stock price performance than that of the industry and the competition. Expansion into
other countries will fuel growth and make future financial estimates more appealing. I
would expect Home Depot to perform well in the future.
36
Note: The industry graph, located in the appendix, shows the performance of the
specialty retailer (home improvement retail) industry as compared to Home Depot,
Lowe’s, and the S&P 500. Home Depot has outperformed the industry, the S&P, and its
main competitor, Lowe’s over 3 months.
The Lower chart shows the year to date performance of Home Depot; it shows that Home
Depot, Lowe’s, and the S&P all track the industry to some extent and that Home Depot
consistently outperforms the industry and its competitor.
V. Valuation
Introduction
After forecasting the financial statements for Home Depot, for ten years into the
future, it is essential to put these values into models in order to determine the value of the
equity. These values are based on assumptions of the future performance of the
company. This section will focus on discounted values at the cost of capital to the
company.
It is important that these valuations be done for several reasons. The market
consensus of the value of the firm should be compared to our calculation of intrinsic
value to determine if the stock is an attractively priced security. Depending on the level
of confidence we have in our forecasts and assumptions about the future prospects of the
firm, we will determine how accurate the valuation model is. Some models carry more
weight than others, but it is necessary to have valuations across a broad range of
variables. These valuations can also assist in assessing where the market thinks most of
the value of the firm lies, either in assets that are already in place, or in the firm’s future.
37
The specific valuations/models to be discussed in this section are:
•
Method of Comparables
•
Discounted Dividends
•
Discounted Free Cash Flows
•
Discounted Residual Income
•
Abnormal Earnings Growth
•
Altman’s Z-score
A sensitivity analysis has been performed where the cost of capital and the growth
rate implied by the market are determined. These implied values can be found on the top
of each valuation spreadsheet.
Cost of Capital
The cost of equity capital used for valuation purposes was calculated to be
11.79% using an equity risk premium of 5.3%. This premium was found from the
difference between a long run average of monthly returns on the S&P 500, and a long run
average of the returns on 20 year treasury bonds. The long term Treasury bond was used
to reduce the effect of short term factors that influence short term rates on t-bills. I
computed the cost of equity using both t-bills and t-bonds and I believe that the rate on
the 20 year treasury yields a closer approximation of the risk premium.
The cost of debt was calculated by using the average rate on long term debt
which was found in the notes to the financial statements. Home Depot’s debt structure is
68% long term debt with an average rate of 4.64%, and 32% short term debt with an
average rate of 1.79% (rate on commercial paper). The tax rate used to calculate the after
tax rate on debt is 37%.
38
Beta was calculated to be 0.99 which is lower than the published Value Line beta
of 1.3. Because of the significant difference between these two numbers, which can be
attributed to short term market factors affecting the firm return, I feel that the Value Line
beta is a better number to use for the purpose of valuation. Home Depot seems to hold
more risk than the average market risk because of the cyclical nature of the home
improvement retail industry.
WACC = (Kd (1-T)) (Vd/Vf) + Ke (Ve/Vf)
WACC = (0.0464(1-0.37) (15881/38331) + 0.1179(22450/38331)
WACC = 8.12%
The Weighted Average Cost of Capital was found using the values stated above
with the knowledge that approximately 41.5% of the firm is financed with debt and
58.5% is financed with equity. The WACC is 8.12%.
Method of Comparables Valuation
The method of comparables valuation was performed using current share prices
and shares outstanding. This method requires that several close competitors of Home
Depot be used to compute ratios and then be averaged. Home Depot most closely
competes with Lowe’s, but more than one competitor is required for the method of
comparables valuation. Five companies were chosen based on market share, and
products sold, and sector of the industry served. Most companies serve home consumers
and contractors, but some focus more on commercial customers.
The Building Materials Home Corporation mainly is a construction services
provider. The Fastenal Company is a wholesale distributor of construction supplies.
This company may not directly compete with home depot, but the companies share
several similar products and for valuation purposes, are comparable. Sherwin Williams
39
Company is involved mainly in the selling of paint and paint supplies. This is more of a
specialty store, but is considered a competitor with Home Depot’s Expo centers, and
Home Depot because of similar product sales. Tractor Supply’s customers are ranchers
and tradesmen. It sells a wide range of products and can be considered a home
improvement retailer even though it targets mainly agricultural customers. Tractor
Supply most closely competes with Home Depot in sales of hardware. Lowe’s is the
most clear and accurate comparison to Home Depot. They directly compete with each
other and stock nearly all of the same products.
The comparables valuation is not considered to be one of the most accurate
measures, as can be seen by the range of values. This range could be caused by a lack of
close competitors due to a concentrated retail home improvement industry. The price
earnings ratio most accurately estimates the actual price of Home Depot’s shares. The
price to sales ratio was the furthest off, possibly because of the different sizes of the
companies used in the valuation. Revenues vary between the retailers because of
company size and market share. According to this valuation model, Home Depot is
overvalued.
Intrinsic Valuation Methods
Discounted Dividends
The Discounted Dividends method of valuation holds more weight in this
valuation process than does the method of comparables, mainly because of the lack of
direct competitors in the industry. Variation in price is not explained well by the
variation in dividends over time. The historical dividend growth rate shows some
consistency, so this rate was used in forecasting of dividends. Steady dividend growth is
expected to be seen in the future.
40
The cost of equity capital was used to discount the future dividends back to 2004.
The total present value of the forecasted 10 years of dividends amounted to 2.75 while
the terminal value, which was calculated assuming no growth on the dividend paid in
year 2014, amounted to 6.60. The stock is extremely overvalued according to this model.
I do not feel that the estimates of the forecasted values of net income are too
conservative. Moderate growth was forecasted and this would cause future dividends to
be smaller.
A sensitivity analysis of the Dividend Discount model shows that a 2.05% cost of
equity capital, or a 9.8% growth factor in the terminal value, would equate the value of
the equity with the market price. The implied cost of equity is not reasonable, but growth
is very reasonable and probable.
Discounted Free Cash Flows
Contrary to the discounted dividend model, the free cash flow model showed the
market price to be smaller than the intrinsic value of the stock. This model has more
explanatory power than the previous two models and carries more weight in the overall
valuation of Home Depot. The terminal value of the free cash flows is calculated using
the expected 2014 free cash flow. The free cash flows have been showing a decreasing
trend according to the forecast, but I do not expect this trend to persist into the future.
The estimated share price according to this model is 51.10. After a sensitivity
analysis of growth in the terminal value and sensitivity of the weighted average cost of
capital it can be determined that the market assumes a 9.69% weighted average cost of
capital. Because the intrinsic value is higher than the current market price, we would
have to assume either a higher weighted average cost of capital, or negative growth to
equate the market price with the intrinsic value.
41
Discounted Residual Income
The discounted residual income valuation model has the most explanatory power
of all the models discussed so far. It links uses dividends to link book values to market
values. For this model, we will assume normal earnings to be calculated by: last years
earnings multiplied by 1+Ke. Because this model values the spread between expected
earnings and normal earnings, it cannot grow in an unbounded manner like discounted
free cash flows. Hence, we are valuing the residual income on a per share basis.
For this model, the implied cost of equity capital that will equate the current stock
price with the intrinsic value is 8.62%. The growth rate to equate the market value to the
intrinsic value is 8.9%. I feel that the implied cost of equity is slightly low for this stock,
but the growth in the terminal value is not unreasonable here. There is an increasing
trend in residual income which implies growth in the terminal value.
According to this model, the market price is overvalued by quite a bit. The value
is estimated to be 24.74. The calculation of the relative values will show where the value
lies in Home Depot. Assets already in place make up 40% of the value, the present value
of residual income makes up 37% of the value, and the future potential of the firm
measure by the terminal value makes up the other 23% of the firms estimated intrinsic
value. This explains that Home Depot is somewhat of a mature firm with a large
percentage of assets in place which lowers the risk of investors. The firm has 23% of its
value coming from future potential which can be seen as a sign of positive future
performance.
Long Run Average Residual Income Perpetuity
This residual income valuation is calculated by taking the difference between the
expected long run return on equity and the cost of equity. This difference is then used to
42
find a perpetuity while accounting for growth in the book value of equity. The return on
equity for Home Depot has been quite stable over the past five years, and I do not
forecast any significant changes in structure. The long run return on equity is 19%. The
historic growth in book value of equity has not been a constant value. There has been
significant fluctuations in this value, and the valuation will be done once assuming no
growth, and once with the implied growth rate. For forecasting purposes, the growth rate
is determined to be 11%.
P/B = 1 + (ROE - Ke) / (Ke - gbve)
P/10.23 = 1+ ((0.19-.1179) / (.1179-0))
P = 16.49 (assuming no growth in book value)
The Implied growth in book value of equity for this valuation is 9.49% which I
believe to be an attainable value. This model implies that the cost of equity is very low,
4.6%. In this model the stock is overvalued. The discounted residual income model is a
better valuation method for Home Depot and seems to better represent the market
consensus price.
Abnormal Earnings Growth Valuation
The objective of this valuation model is to value a stock with the assumption that
dividends are irrelevant. To do this it is necessary to assume that the dividend will be
reinvested at the cost of equity capital. The difference between the cumulative dividend
earnings and the normal earnings are the abnormal earnings. The total discounted
abnormal earnings growth added to the earnings per share and the present value of the
terminal value will be the estimated price.
43
Our abnormal earnings seemed to have a significant amount of variation. To
reduce the variation I chose to take the average of the forecasted abnormal earnings to
find the terminal value. If I had used the final year’s abnormal earnings, the stock would
have been extremely overvalued, which, based on the fundamentals of the business, I do
not believe to be the case. A cost of equity capital that is implied by the market was
found to be 9.45%. The implied growth rate is 10.20%. The terminal value was
calculated assuming no growth in abnormal earnings.
Altman’s Z-Score
Z-Score based on year-end 2003 Annual report with the Market Value of Equity
based on the current market price of $42.29 which was the same price used in our
valuations. Home Depot’s Z-Score fell higher than the 2.7 score required for credit
worthiness and falls in line with the estimated cost of debt.
Results and Conclusion
These valuation models offer a nice breakdown of the business and give
explanations of where the value of Home Depot is derived from. In the residual income
model, it was determined that most of Home Depot’s value comes from assets that are
already in place. Based on the valuation models used, Home Depot is overvalued in all
models except for the discounted free cash flows model. The method of comparables
valuation for the price earnings ratio was only slightly overvalued.
44
Specific reasons for the difference between the value determined by a market
consensus and by these models are as follows: The estimation of the cost of equity and
the equity risk premium has a significant effect on the estimated value of the stock. For a
company with most of its value in assets already in place, the estimated cost of debt may
have been slightly high. If this were true, then the stock would be only fully valued.
Another factor that would have a substantial impact on the valuation is the forecasts the
valuations are based on. After comparison of these forecasts against published forecasts,
it is evident that the forecasts used in this valuation are more conservative in terms of
sales growth and earnings growth. This would have a similar effect that overestimating
the cost of capital would have. I am confident that using the published beta of 1.3 instead
of the beta determined in the regression analysis has yielded more accurate results.
Because the forecasts used in this valuation are on the conservative side, I would say that
Home Depot is slightly overvalued and while it is not being traded currently at an
attractive price, the company’s future looks positive.
VI. Analyst Recommendation
Home Depot is a financially sound company and performs well when compared to
its competitors. Based on current business conditions and the potential growth
opportunity facing Home Depot, we feel that the bottom line will continue to grow at a
healthy rate above the competition in the near future. We believe that the relatively low
levels of debt, slightly wider margins, and lower costs make Home Depot an attractive
investment for the long run. Shares of Home Depot are currently trading at a premium to
what we believe is the intrinsic value. This premium is possibly derived from the
market’s belief that better than predicted growth will be seen from expansion into foreign
markets, specifically China.
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Home Depot is a well managed business that has had a historically above average
performance. Because the shares currently appear to be slightly overvalued, we
recommend Home Depot as a hold. Risks to this recommendation include the threat of a
possible terrorist attack, and because Home depot operates in a cyclical industry,
fluctuations in economic conditions as well. Overall, Home Depot is a strong company
that is poised to outperform its industry and the market.
VII. References
1.
2.
3.
4.
5.
6.
7.
8.
Home Depot Annual Reports/Statements
Home Depot company website
Zacks.com
Yahoo finance
MSN Money
Edgarscan
Value Line
BigCharts.com
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VIII. Appendix
47
Trend (Time Series) Analysis
Home Depot Ratio Analysis
2000
2001
2002
2003
2004
Current ratio
quick asset ratio
accounts receivable turnover
days outstanding receivables
inventory turnover
days supply of inventory
working capital turnover
1.75
0.21
72.79
5.01
5.53
66.06
14.06
1.77
0.23
64.33
5.67
5.32
68.57
13.48
1.59
0.53
61.03
5.98
5.63
64.80
13.87
1.48
0.41
58.48
6.24
5.33
68.49
15.00
1.40
0.41
59.77
6.11
5.08
71.84
17.17
0.30
0.19
0.06
2.25
0.14
0.19
0.30
0.20
0.06
2.14
0.12
0.17
0.30
0.21
0.06
2.03
0.12
0.17
0.31
0.21
0.06
1.94
0.12
0.19
0.32
0.21
0.07
1.88
0.12
0.19
0.06
-92.88
84.62
0.10
-199.57
698.00
0.07
-176.14
1189.80
0.07
-157.57
687.14
0.06
-110.42
12.90
0.16
0.06
0.10
0.14
0.06
0.09
0.15
0.06
0.09
0.16
0.06
0.10
0.16
0.07
0.11
0.11
9.03
13.56
26.92
3.68
3.76
0.05
0.67
0.38
0.05
0.06
-0.11
0.21
0.12
8.13
16.22
22.50
3.42
3.50
0.04
0.64
0.43
0.09
0.09
-0.14
0.20
0.08
12.22
10.89
33.53
3.42
3.48
0.39
0.92
0.46
-0.07
0.06
-0.13
0.19
0.09
11.40
8.80
41.47
3.31
3.39
0.28
0.60
0.52
-0.05
0.06
-0.13
0.21
0.09
11.13
8.57
42.57
3.17
3.23
0.30
0.69
0.54
-0.09
0.06
-0.14
0.22
Liquidity
Profitability
gross profit margin
operating expense ratio
net profit margin
asset turnover
return on assets
return on equity
Capital Structure
debt to equity ratio
times interest earned
debt service margin
Other
operating return on assets
NOPAT margin
EBITDA margin
operating working capital to sales
ratio
operating working capital turnover
accounts payable turnover
days' payables
net long term asset turnover
PP&E turnover
cash ratio
operating cash flow ratio
liabilities to equity ratio
net debt to equity ratio
debt to capital ratio
dividend payout ratio
sustainable growth rate
48
Cross Sectional (Benchmark) Analysis
Lowes
1999
2000
2001
2002
2003
1.55
0.30
107.54
3.39
4.10
89.07
12.02
1.43
0.21
116.65
3.13
4.11
88.91
15.07
1.63
0.34
133.55
2.73
4.36
83.71
11.62
1.56
0.36
154.02
2.37
4.65
78.44
13.31
1.53
0.40
235.40
1.55
4.63
78.81
13.30
0.28
0.20
0.04
1.76
0.07
0.14
0.28
0.20
0.04
1.65
0.07
0.15
0.29
0.20
0.05
1.61
0.07
0.15
0.30
0.21
0.06
1.64
0.09
0.18
0.31
0.20
0.06
1.62
0.10
0.18
debt to equity ratio
times interest earned
debt service margin
0.40
13.53
19.55
0.54
11.61
26.68
0.58
10.36
27.22
0.46
13.96
92.97
0.36
17.66
40.95
operating return on assets
NOPAT margin
EBITDA margin
operating woking capital to sales ratio
operating working capital turnover
accounts payable turnover
days' payables
net long term asset turnover
PP&E turnover
cash ratio
operating cash flow ratio
liabilities to equity ratio
net debt to equity ratio
debt to capital ratio
dividend payout ratio
sustainable growth rate
0.12
0.05
0.07
0.06
17.53
7.36
49.63
3.00
3.07
0.24
0.49
0.92
0.28
0.29
-0.07
0.15
0.11
0.05
0.07
0.06
17.55
7.79
46.87
2.61
2.67
0.16
0.39
1.07
0.46
0.35
-0.07
0.16
0.11
0.05
0.08
0.05
18.28
9.18
39.76
2.51
2.56
0.28
0.53
1.06
0.46
0.37
-0.06
0.16
0.14
0.06
0.10
0.04
28.09
9.50
38.41
2.52
2.56
0.31
0.75
0.94
0.32
0.31
-0.04
0.19
0.15
0.06
0.10
0.03
39.95
8.97
40.68
2.50
2.58
0.37
0.72
0.85
0.21
0.27
-0.05
0.19
Liquidity
Current ratio
quick asset ratio
accounts receivable turnover
days outstanding receivables
inventory turnover
days supply of inventory
working capital turnover
Profitability
gross profit margin
operating expense ratio
net profit margin
asset turnover
return on assets
return on equity
Capital
Structure
Other
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53
54
55
56
57
58
59
60
61
62
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