Caution: This Stock’s Rally Could End

Over the past year, shares of home materials retail giant Home Depot (NYSE:HD) have been big winners, rising roughly 30%, far above the S&P 500‘s 13% return over the past twelve months. But, the rally in Home Depot stock has come under pressure recently. Over the past two months, HD stock is up just 1.5%, less than half the market’s 3.5% return over that same stretch.

In other words, Home Depot has gone from relative over-performance over the past year, to relative underperformance over the past two months.

Why? One word: valuation.

A year ago, Home Depot stock was trading around 16- to 18-times forward earnings, roughly 15% below the stock’s five-year-average forward earnings multiple of 20.

Over the past two months, though, Home Depot has featured a 22- to 23-times forward earnings multiple, a 10%-plus premium to the stock’s average valuation.

Connecting the dots, as Home Depot has gone from relatively undervalued to relatively overvalued over the past year, shares have simultaneously gone from beating the market, to trailing the market.

This isn’t a coincidence. At present, although the Home Depot growth narrative is healthy, valuation is a headwind for Home Depot stock. Ultimately, this valuation headwind will keep HD stock stuck in neutral for the foreseeable future.

The Home Depot Growth Narrative Is Healthy
In both the near- and long-terms, the Home Depot growth narrative is healthy.

In the long-term, you have a home materials retail giant that is leveraging its unparalleled size and reach to even further expand dominance in the secular growth home retail market.

For example, take the Home Services segment. Over the past few years, Home Depot has relied on its unparalleled size to create a streamlined, all-in-one home installation and repair business that matches consumers to contractors more efficiently than anyone else in this market.

That’s just one example of many wherein Home Depot has used its size to launch a new business vertical in the home retail market, and leveraged its size to turn that business vertical into a de facto solution across the entire market. The result? Home Depot is becoming more dominant in a stable growth home retail market.

Historically speaking, this is a 4-6% revenue growth industry in the U.S. Not surprisingly, Home Depot’s revenues have risen at a compounded annual growth rate of 6-7% over the past five years. Thus, so long as the U.S. home improvement market continues to grow at a ~5% rate over the next few years, then Home Depot projects as 5%-plus revenue grower over that stretch, too.

In the near-term, the U.S. economy is starting to pick up steam thanks to easing U.S.-China trade tensions. The non-manufacturing and manufacturing PMI readings both improved in October, led by new orders and activity. New home sales continue to trend higher. Leading indicators data from the OECD shows that U.S. economic growth trend declines are moderating.

Net net, the U.S. economic picture is improving, and as it continues to improve, it should result in more robust growth at Home Depot.

Home Depot and Valuation Friction
Although both the near- and long-term growth narratives at Home Depot are healthy, Home Depot stock is fully priced for this healthiness, meaning that near-term returns will be muted by valuation friction.

As stated in the intro, Home Depot has gone from relatively undervalued to relatively overvalued over the past year. Bulls could argue that today’s relative overvaluation is warranted given the improving economic backdrop. But, that argument would miss the bigger picture. Although Home Depot’s numbers should improve, they are improving from record low levels.

Consider this. Home Depot’s sales are expected to rise just over 2% this year on a 4% increase in comparable sales. Both of those growth rates are multi-year low growth rates. Meanwhile, margins are expected to rise only marginally this year, a sharp divergence from the big margin expansion years Home Depot experienced earlier this decade. And, profit growth is expected at less than 3% this year. Since 2014, Home Depot has fired off nothing but double-digit profit growth rates.

Broadly, then, Home Depot is presently reporting multi-year lows in revenue growth, margin expansion, and profit growth. Yet, the forward earnings multiple on Home Depot stock sits more than 10% above its historical average.

This discrepancy doesn’t make sense. It ultimately implies that HD stock is overvalued. So long as this overvaluation persists, shares will likely continue to under-perform.

Bottom Line on Home Depot Stock
Home Depot is a great company, and Home Depot stock was a great stock to buy… back in late 2018, when the chips were down and shares were undervalued.

Today? Not so much. On the heels of a 30% rally over the past year, Home Depot stock is now battling valuation headwinds. So long as these valuation headwinds stick around, shares will likely be stuck in neutral.

— Luke Lango

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Source: Investor Place