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 has been trading at a higher multiple than its peers. When growth expectations are higher, the market tends to value companies at higher multiples.
The better-than-expected 3Q16 earnings and the rise in home prices in the US have increased investor confidence, leading to a rise in Home Depot’s share price and its PE multiple. Since the announcement of 3Q16 earnings, Home Depot’s PE multiple has risen from 18.3x to 18.5x.
Although Lowe’s 3Q16 earnings were lower than expected, the rise in home prices has increased investors’ confidence, leading to a rise in its PE multiple. As of December 5, 2016, Lowe’s was trading at 16.3x, up from 15.3x before the company’s 3Q16 earnings. On the same day, peers Williams-Sonoma (WSM) and Bed Bath & Beyond (BBBY) were trading at 15.3x and 9.5x, respectively.
For the next four quarters, analysts are expecting Home Depot and Lowe’s to post EPS growth of 12.6% and 20.2%, 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.
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.