You should look at valuation multiples when deciding whether to enter or exit a stock. Valuation multiples are driven by perceived growth, risks and uncertainties, and investors’ willingness to pay.
There are various multiples available to access a stock’s valuation. For this analysis, we chose the PE (price-to-earnings) multiple due to Home Depot’s (HD) high earnings visibility. The forward PE multiple is calculated by dividing a company’s current share price by its EPS (earnings per share) forecast for the next 12 months.
Home Depot’s PE multiple
The rise in house prices and improvement in the US economy, with the rise in labor wages and decline in unemployment, appear to have increased investors’ confidence. They led to a rise in Home Depot’s share price and PE multiple. As of January 23, 2017, Home Depot was trading at a PE multiple of 19.4x—up from 18.3x—just before the announcement of its 3Q16 earnings.
Home Depot (HD) and Lowe’s (LOW) are leaders in the US home improvement sector. 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. On the same day, Home Depot’s peers Lowe’s, Williams-Sonoma (WSM), and Bed Bath & Beyond (BBBY) are trading at PE multiples of 16.1x, 13.3x, and 8.6x, respectively.
To enhance customer experience, the company implemented a customer order management system and the Buy Online Deliver from Store program. To optimize its supply chain, the company has been investing in a multiyear project—Project Sync. If these initiatives fail to generate the expected revenue, increased expenses due to the implementation of these initiatives will put pressure on the company’s margins. They will lower Home Depot’s earnings for the next four quarters.
For the next four quarters, analysts expect Home Depot’s EPS to rise 12.6%. Its current share price might have already accounted for the rise. If the company’s results come in lower, Home Depot stock could face selling pressures. The results could lower Home Depot’s PE multiple and vice versa.
You can mitigate these company-specific risks by investing in the Consumer Discretionary Select Sector SPDR ETF (XLY). XLY invested more than 9.4% of its holdings in home improvement companies such as Home Depot and Lowe’s.