Is Home Depot Overvalued?

Home Depot (NYSE: HD) has been doing very well lately; its revenues increased by $5.34 billion during 2015, but is it really worth the $130.46 a share it was trading for on March 24, 2016?

The company’s archrival; Lowe’s (NYSE: LOW) which has an almost identical business model and a similar record of impressive revenue growth, was only trading at $74.77 a share on March 24, 2016. If you compare the two by share price alone, Home Depot sounds over valued but is it?

The revenue growth at Home Depot has been phenomenal, in January 2014 the company reported $78.81 billion in revenue that number grew to $83.18 billion in January 2015, and $88.52 billion in January 2016. Yet one can say the same thing of Lowe’s, it reported $53.42 billion in revenue in January 2014, $56.22 billion in revenue in January 2015 and $59.07 billion in January 2016.

Does Home Depot Make Money?

Skeptical value investors will ask if Home Depot is making money on that revenue. The answer is yes, the revenue growth is actually generating profit.

It did report a net income of $7.009 billion on January 31, 2016, up from $6.34 billion a year earlier and $5.385 billion in 2014. Home Depot also reported a high profit margin (7.01%) and a strong free cash flow for a retailer $1.587 billion on January 31, but I see nothing here to justify the $130.46 share price.

Despite that Home Depot does generate a lot cash it reported $9.373 billion in cash from operations on January 31, 2016, an increase of $1.131 billion from a year earlier when the figure $8.242 billion.

Home Depot also has some float – it reported $2.216 billion in cash and short and term investments on January 31 – which is good for a retailer. That was up from $1.723 billion on the same date in 2015.

Good Company, Lousy Investment

These numbers show us that Home Depot is a good company with a business model that makes a lot of money yet it is a very lousy investment because it is overpriced. There are other cheaper retailers that offer a similar performance including Lowe’s.

Home Depot did give investors a dividend yield of 1.89% on March 24, 2016. It also provided investors with an 85.27% return on equity. Unfortunately that return seems to come from the high share price and not Home Depot’s actual performance.

My advice to investors would be to wait until Home Depot’s share price falls to a realistic level to buy. This is a good company; but it’s a good $100 a share stock, not a $130 a share stock.

Home Depot and Lowe’s Uncertain Future

Naturally investors will be wondering if big-box home improvement stores such as Lowe’s and Home Depot are a good long term value investment. After all they do sell a lot of stuff that Amazon.com (NASDAQ: AMZN) will probably never be able to offer such as lumber and large appliances.

These chains are also capitalizing upon some of the trends created by growing income inequality and wage stagnation in the United States. These include increased interest in thrift and do it yourself, and a desire for low prices. Rapidly rising real estate values and the media hype they generate also increase the demand for home improvement supplies.

Unfortunately it is not clear how long these trends can last, particularly rising real estate values which are now showing signs of being a bubble. Another outside force helping Home Depot’s business is low interest rates which makes both mortgages and home equity loans (which are used to finance home improvement projects) very cheap. Low interest rates are an undependable growth driver because such rates are set by the Federal Reserve, which can change its policy at any point.

A danger for both Home Depot and Lowe’s would be a sudden rise in interest rates. Such an increase could burst the real estate bubble and cause sales at home improvement stores to plummet. Another danger for Lowe’s would be that the Fed could decide to crash the real estate market by raising interest rates. This could occur if the property market were to become overheated.

Longer-term dangers include an aging population, which means there will be more people who are physically incapable of doing home repairs. An older population also means more people living in retirement communities and apartments instead of houses.

Is Home Ownership Declining?

A related threat is the growing portion of the population that seems to prefer renting to home ownership which means fewer potential Home Depot customers. The Wall Street Journal found that the percentage of renters in nine of the 11 largest US cities increased between 2006 and 2013.

For example the percentage of renters in Atlanta grew from around 46% to 49% during that period. In Philadelphia the percentage of renters grew by around 8% rising from around 36% in 2006 to 44% in 2013. Renters now make up a majority of the population in several cities with reputations for high rates of home ownership and low real estate low prices such as Houston.

The increase in renters is a double-edged sword for Home Depot because it means more landlords who need to maintain all those rental units. The growing popularity of rentals also means more investors and speculators fixing up older units. Naturally all those would be landlords will need tools and materials for their projects – which could generate more sales at Home Depot.

My take is that home improvement could be a value investment area, but Home Depot is far too overpriced to be a value. Stay away from this stock until it comes down to earth and if you want to invest in a home improvement store, buy Lowe’s.