Investors should look at valuation multiples when deciding whether to enter or exit a stock. Valuation multiples are driven by perceived growth, risk and uncertainties, and investors’ willingness to pay.
There are various multiples available to assess the valuation of a stock. For this analysis, we’ve chosen the PE (price-to-earnings) ratio due to the high earnings visibility of Home Depot (HD) and Lowe’s (LOW). The forward PE ratio is calculated by dividing the current share price by the forecasted EPS for the next 12 months.
Home Depot (HD) and Lowe’s (LOW) are the leaders in the home improvement sector in the US. With higher margins and revenue growth, Home Depot (HD) has been trading at a higher multiple than its peers. When growth expectations are higher, the market tends to value companies at higher multiples. As of September 13, 2016, HD was trading at a PE multiple of 18.7x. During the same period, other peers like Lowe’s (LOW), Bed Bath & Beyond (BBBY), and Williams-Sonoma (WSM) were trading at 16.2x, 8.7x, and 13.9x, respectively.
Although Home Depot’s 2Q16 earnings were in line with analysts’ estimates, the slowdown in the US economy and fears of a rise in interest rates have made investors skeptical about investing in Home Depot. This has led to a decline in HD’s PE multiple. Since the beginning of fiscal 2016, HD’s PE multiple has fallen from 22.1x to 18.7x. The lower-than-expected 2Q16 earnings and other macro factors have brought Lowe’s (LOW) PE multiple down from 19.9x at the beginning of 2016 to 16.2x.
Analysts have forecasted HD and LOW to post EPS of $6.7 and $4.4, respectively, in the next four quarters, which represents a year-over-year growth of 12.8% and 21.6%, respectively. These EPS growth projections might have already been factored into the current share prices of HD and LOW. If the companies’ results come in lower, then the stocks could face selling pressure, which could bring the PE multiples of HD and LOW down, and vice versa.
You can mitigate these company-specific risks by investing in the Consumer Discretionary Select Sector SPDR Fund (XLY), which has invested more than 10% of its holdings in home improvement companies like HD, LOW, and BBBY.
Next, we’ll look at what analysts are recommending for Home Depot and Lowe’s.