Home Depot Inc (HD, Financial) has raised its quarterly dividend to 69 cents per share or $2.76 on an annual basis from its previous 59 cents per share or $2.36 per year.
The day the company announced the dividend increase, the stock moved higher. However, the stock is off by 5% on a year-to-date basis.
The company recently posted its financial results for the fourth quarter. Home Depot reported revenue of $21 billion while its profit advanced to $1.17 per share. Moreover, the results exceeded the analysts’ estimates of 7 cents in EPS and beats $610 million in revenue. In addition to that, the company’s revenue increased 9.6% in the fourth quarter year over year.
Let's try to find the intrinsic value of the stock and compare it with its trading price. But first, let's see the relative valuation.
The company is trading at a P/E ratio of 23.5x, which is expensive when compared to Lowe’s Companies (LOW, Financial):
| Company | P/E Ratio | Dividend Yield (%) |
| HD | 23.50 | 1.9 |
| LOW | 21.60 | 1.6 |
Intrinsic value
The Yahoo! (YHOO, Financial) Finance consensus price target is $142.05, representing an upside potential of 13.1%, so now let's estimate the fair value of the firm. For that purpose I will use the Dividend Discount Model (DDM). In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).
Once the appropriate model has been selected, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.
Let's estimate the inputs for modeling:
First, we need to calculate the different discount rates – i.e., the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium
Risk-Free Rate: Rate of return on LT Government Debt: RF = 3.03%[1]. This is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. It is more appropriate to use this rate.
Gordon Growth Model Equity Risk Premium = (one-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[2]
Beta: From Yahoo! Finance we obtain a β = 0.9598
The result given by the CAPM is a cost of equity of: rHD = RF +beta HD [GGM ERP] = 4.9% + 0.9598 [11.43%] = 15.87%
Dividend growth rate (g)
The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm's debt-to-equity ratio is unchanged and it doesn´t issue new equity.
g = b x ROE
b = retention rate
ROE = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
The “PRAT” Model:
g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
Collecting the financial information for the last three years, each ratio was calculated; then to have a better approximation I proceeded to find the three-year average:
| Retention rate | 0.60 |
| Profit margin | 0.07 |
| Asset turnover | 1.95 |
| Financial leverage | 2.88 |
Now, is easy to find the g = Retention rate Ă— Profit margin Ă— Asset turnover Ă— Financial leverage = 23.04%
Because for most companies, the GGM is unrealistic, let's consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high-growth stage, until it reverts to the long-run rate. In other words, a smoother transition to the mature phase growth rate that is more realistic.
Dividend growth rate (g) implied by Gordon growth model (long-run rate)
With the GGM formula and simple math:
g = (P0.r - D0)/(P0+D0)
= ($125.61 × 15.87% – $2.76) ÷ ($125.61 + $2.76) = 13.38%.
The growth rates are:
| Year | Value | g(t) |
| 1 | g(1) | 23.04% |
| 2 | g(2) | 20.62% |
| 3 | g(3) | 18.21% |
| 4 | g(4) | 15.79% |
| 5 | g(5) | 13.38% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Now that we have all the inputs, let's discount the cash flows to find the intrinsic value:
| Year | Value | Cash Flow | Present value |
| 0 | Div 0 | 2.76 | |
| 1 | Div 1 | 3.40 | 2.931 |
| 2 | Div 2 | 4.10 | 3.051 |
| 3 | Div 3 | 4.84 | 3.112 |
| 4 | Div 4 | 5.61 | 3.110 |
| 5 | Div 5 | 6.36 | 3.043 |
| 5 | Terminal Value | 289.30 | 138.510 |
| Intrinsic value | 153.76 | ||
| Current share price | 125.61 | ||
| Upside Potential | 22% |
Final comment
Intrinsic value is above the trading price by 22%, so according to the model and assumptions, the stock is undervalued. Considering a margin of safety (usually a 20%) we could say that the stock is a good stock to buy.
However, we must keep in mind that the model is a valuation method, and investors should not rely on it alone in order to determine a fair (over/under) value for a potential investment.
Hedge fund gurus like Jim Simons (Trades, Portfolio) and John Hussman (Trades, Portfolio) have initiated new positions in the last quarter of 2015 with 252,200 and 25,000 shares, respectively. Also bullish were John Burbank (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Steven Cohen (Trades, Portfolio) and Ken Fisher (Trades, Portfolio) as well as RS Investment Management (Trades, Portfolio) and Pioneer Investments (Trades, Portfolio).
Disclosure: As of this writing, Omar Venerio did not hold a position in any of the aforementioned stocks.
[1] This value was obtained from the U.S. Department of the Treasury.
[2] These values were obtained from Bloomberg's CRP function.
