Word on Wall Street: Home Depot's Debate Centers on Valuation

Word on Wall Street: A former Wall Street analyst discloses the topics that equity analysts and hedge fund managers are currently talking about. 

Home Depot is a widely admired company on Wall Street. Overall sentiment among Wall Street analysts is bullish, with the majority of analysts holding largely positive views on the stock. While there aren't many bears, there are analysts that believe the stock has run its course. Below are the key issues that these analysts are talking about.

 

Key Issue 1: Is valuation fair?

The most commonly debated issue is Home Depot's rich valuation. Trading at 20x 2016 EPS estimates (near 5-year highs), Home Depot's strong historical execution and stable industry demands a high multiple among investors. At its current price, is valuation fair?

Generally, bulls argue that the high multiple is justified given 1) Home Depot's strong comp performance, 2) near-term upside to consensus estimates (detailed in the next section), 3) tailwinds from a strong housing market, and 4) Home Depot's track record of returning capital to shareholders.

Bears simply argue that the multiple suggests little room for error given consensus earnings growth expectations of 15% in 2016. The downside risk fairly balances the limited upside, making Home Depot not look especially appealing.

 

Key Issue 2: How much more earnings upside is there?

Tied to the issue of valuation is how much earnings upside is left compared to consensus estimates. Home Depot has grown earnings at a 22% CAGR over the last 5 years, which has invited 1) higher earnings expectations (tied to the valuation issue), and 2) raised questions over how long this can continue.

Bulls argue that there is still significant upside. On the sales front, the home improvement market remains in its early innings as housing turnover is still improving, home prices are improving, and home improvement spend is still well-below historic averages. Home Depot also has several company-specific initiatives driving additional sales growth as well, including a continued focus on customer service levels and a strong e-commerce site that is considered by many to be best-in-class. In turn, sales growth is likely to drive profitability gains as they leverage their SG&A expense. Longer-term, some bulls see the potential for margin to approach mid-teens (from the 13% level that they're expected to end the year on). 

Bears generally argue that while there is likely some upside remaining, they worry about the rate of improvement as the company approaches longer-term margin targets.  If there is any sign of a slowdown, the stock will likely react negatively. 

Note: 2015 and 2016 EPS numbers are consensus estimates.

Note: 2015 and 2016 EPS numbers are consensus estimates.