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 chose the PE (price-to-earnings) ratio due to Home Depot’s (HD) high earnings visibility. The forward PE ratio is calculated by dividing the current share price by the EPS forecast for the next 12 months.
Home Depot’s PE multiple
Although the housing market is showing improvement, fears of an interest rate hike and a slowdown in the US economy made investors skeptical about investing in Home Depot. Also, recent reports of lower-than-expected results by other retailers led to a fall in Home Depot’s share price and PE multiple. As of November 8, 2016, the company was trading at PE multiple of 17.9x—down from 20.4x before the announcement of its 2Q16 earnings.
With higher margins and revenue growth, Home Depot has been trading at a higher multiple than its peers. When growth expectations are higher, the market tends to value companies at higher multiples. Comparatively, Lowe’s (LOW), Bed Bath & Beyond (BBBY), and Williams-Sonoma (WSM) are trading at PE multiples of 14.7x, 8.3x, and 13.2x, respectively.
Risks and uncertainties
To improve its same-store sales growth, the company enhanced customer experience through technological advancements. If these initiatives fail to deliver the desired result, the increase in expenditure due to the implementation of these initiatives can put pressure on the margins. It would lower the company’s EPS. For the next four quarters, analysts expect the company to post EPS of $6.74—growth of 13.4% from the same quarters in the previous year. Home Depot’s current share price might have already factored in the EPS growth. If the company’s results come in lower, then the stock could face selling pressure. It could bring its PE multiples down and vice versa.
You can mitigate these company-specific risks by investing in the Consumer Discretionary Select Sector SPDR ETF (XLY). The fund invested more than 10% of its holdings in home improvement companies such as Home Depot, Lowe’s, and Bed Bath & Beyond.
Next, we’ll look at analysts’ recommendations and price targets for the next 12 months.