In this article we evaluate the relative value of Home Depot Inc. (NYSE:HD ) and Lowe's Companies Inc. (NYSE:LOW ) from a business owner's perspective. Employing a business owner's perspective to investing is a style of value investing popularized by Warren Buffett among others. One important aspect of a business owner's perspective to investing is looking closely at the management decision of how much of the earnings to pay out in the form of dividends and how much to retain. In particular, we will evaluate the two companies with a framework suggested by Mr. Buffett in his 1984 letter to Berkshire Hathaway shareholders. In the letter, Mr. Buffett stated:
"For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors." - Source: Berkshire Hathaway, 1984 Letter to Shareholders.
Please look at Table 1 in which we look at the inverse of the P/E ratio for Home Depot and Lowe's. The earnings yield has the benefit of quantifying what return at the current price can the investor expect. Earnings per share represent profits that is due to the shareholders. The management of the firm, entrusted with shareholder capital, decides how much of the capital to pay out in the form of dividends and how much to keep and reinvest in the business which, in theory, will ultimately benefit shareholders. From this table it appears that Lowe's is the better deal. Investors today will get 111 basis points more yield from investing in Lowe's than Home Depot, ceteris paribus.
Source: Prices are closing prices on August 29th. Prices and forward earnings estimate is from Seeking Alpha.
In Table 2, we take a look at the value of each stock relative to the cost of equity as measured by the Capital Asset Pricing Model (CAPM). These companies operate in the same industry and given the same equity risk premium and 10-year treasury rate, the main determinant of the cost of equity will be the beta. We discount the forward earnings by the cost of equity to get the implied value. We compare the implied value to the current price quoted in the previous table to gauge the relative value. Again, it appears that Lowe's is a better deal because it is priced at a lower premium than Home Depot.
Source: www.cnbc.com for betas and 10-year treasury rates on August 29th, 2022. The equity risk premium is an estimate by the author. Premium to implied value is relative to closing price on August 29th.
Next, we take a closer look at growth.
Table 3 presents the earnings growth rate for the fiscal period 2015 to 2021. For the entire period presented Lowe's has a better growth rate. This is mainly because of the spectacular growth in earnings during the pandemic. The growth rate of Lowe's earnings from 2019 to 2021 is almost double that of Home Depot. If you look at only 2015 to 2019 and consider this a "normal" time period then Home Depot exhibits 220 basis points more growth than Lowe's.
Source: Home Depot Inc. 10-K from 2015 to 2021 and Lowe's Companies Inc. 10-K for 2015 to 2021
In Table 4 we look at dividend growth. Interestingly, both companies have been relatively stingy as of late with regard to boosting dividends. The growth in dividends for both companies from 2019 to 2021 was below the growth rate of dividends for the entire period presented despite the two companies achieving above average earnings for the period. This suggests that neither company is sure if the pandemic-related earnings bump achieved is sustainable and want to manage earnings and dividend payouts to operate in an environment of financial comfort. Better to be stingy now than have to moderate dividends payout later. With the exception of the 2019 to 2021 time period, Home Depot has a better dividend growth record, though Lowe's dividend growth is nothing to sneeze at.
Source: Home Depot and Lowe's 10-K for 2015 to 2021.
Given the observation that the earnings growth rate during the pandemic years were above average and the meager dividend payouts during those years it is reasonable to drop off the last two years from our analysis moving forward. They are not representative of what we can expect henceforth. We emphasize the metrics during the 2015 to 2019 time period for the remainder of this article.
So far, we have evaluated earnings and dividends. Now we examine the portion of the earnings that is retained.
In business theory, earnings in a particular year can be attributed to all the capital invested in the business up until just before that particular year. So, in theory, earnings in 2019 for a business can be attributed to all the invested capital in the business from inception up until the end of 2018. In 2019, the capital was put to use and delivered earnings for the owners of the business. We are going to narrow the scope and look at the retained earnings from 2015 to 2018 and attribute the earnings in 2019 to the retained earnings from 2015 to 2018.
Source: Mary Buffett and David Clark. The Buffettology Workbook. Simon & Schuster 2001
Please take a look at Table 5 which exhibits retained earnings for Lowe's.
Source: Author's calculation, Lowe's 10-K for 2015 to 2019. I have omitted the figures marked * because they are not relevant for this table.
From 2015 to 2018 Lowe's retained a cumulative of $10.95 of shareholder's earnings. That shareholder capital was employed in 2019 to generate $5.74 per share of earnings which is an increase of $2.45 from the 2015 earnings per share of $3.29. So, we can say that management kept $10.95 of shareholder money and gave shareholders a $2.45 bump in earnings for the time period presented. The "return on retained" is 22.37% which is a very good number and exceeds the inflation during the time-period comfortably.
In Table 6 we do the same exercise for Home Depot. From 2015 to 2018 Home Depot retained $16.13 of investor money. Shareholder capital was put to use in 2019 and generated and EPS of $10.25 which was $4.79 better than the $5.46 earned per share in 2015. The "return on retained" is a fantastic 29.70%.
Source: Author's calculation, Home Depot's 10-K for 2015 to 2019. I have omitted the figures marked * because they are not relevant for this table.
It is also worth mentioning that Home Depot has a higher payout ratio than Lowe's. They are giving shareholders more money and are more efficient with the amount they retain.
We have looked at earnings, the portion of earnings paid out in dividends and the portion of earnings that is retained. We now turn to how the market reacts to these management-driven decisions.
Please take a look at Table 7 which shows the earnings of Lowe's and the average share price for the particular year. Using a similar logic as we have employed, we can say that from 2015 to 2018 Lowe's retained $10.95 of shareholder money and created a market value of $35.36. The average share price in 2019 was $107.29 and the average share price in 2015 was $71.93 which provides a difference of $35.36. For every dollar that Lowe's management retained during the period they created $3.23 in value which is a very good number and passes Mr. Buffett's test easily.
Source: Yahoo! Finance for the share prices. Author's calculation and Lowe's 10-K for 2015 to 2019.
In Table 8 we do the same exercise for Home Depot. From 2015 to 2018 Home Depot retained $16.13 of investor money. The retained earnings created a market value of $90.41. This figure is a result of the difference between the average share price of 2019 minus the average share price of 2015. So, for every dollar retained, Home Depot created $5.60 market value for shareholders which is pretty amazing.
Source: Yahoo! Finance for the share prices. Author's calculation and Lowe's 10-K for 2015 to 2019.
The foregoing analysis has centered on the relative valuation of Home Depot and Lowe's. Next, we attempt to connect some of the insights gleaned with what we can observe from the operating record of the two companies.
In a general sense, a business can employ two strategies for profitability. They can sell based on volume at a low cost or they can sell at premium prices which doesn't quite have the turnover but comes with healthier margins. In a simplistic sense, a business can sell based on price or volume. Quality or quantity. Using this frame, please take a look at Table 9 which shows some operating ratios for Lowe's. Please note the inventory turnover and the gross and operating profit margins. Lowe's, on average, sells their entire inventory over four times a year. They have healthy gross and operating margins, though some compression in the gross margins is evident. There is also a declining trend for the inventory turnover ratio from 2016 to 2019.
Source: Author's calculation, Lowe's 10-K for 2014 to 2019.
For Table 10 we have the same operating data for Home Depot. On average, Home Depot sells their entire inventory five times a year and has a slightly better gross margin and significantly better operating margin than Lowe's. It is at the operating margin level and the inventory turnover level that Home Depot handily beats Lowe's. And there is also no obvious margin compression. At a fundamental analysis level, this probably explains the valuation discount of Lowe's relative to Home Depot in the two tables at the top of the article.
Source: Author's calculation, Home Depot's 10-K for 2014 to 2019
Price is what you pay and value is what you get. We have seen that Home Depot seems to have a better operating performance than Lowe's but it is also priced higher on a relative basis than Lowe's. Which one is the better investment?
One way to resolve this is to consider is look at the P/E ratio relative to growth or the PEG ratio. Please take a look at Table 11. The earnings growth rate is taken from Table 3.
Source: Yahoo! Finance for the share prices, Seeking Alpha for forward earnings estimate and author's calculations.
Judging from the PEG ratio, Lowe's seems to be the better buy by a slight margin. Similar to the P/E ratio, a lower PEG ratio is preferable, ceteris paribus. It is worth pointing out that Peter Lynch, who popularized the PEG ratio, believed that P/E ratios should be equal to earnings growth which would imply a value of 1 for fair value.
Source: Peter Lynch and John Rothchild. One Up on Wall Street: How to use What You Already Know to Make Money in the Market. Simon & Schuster 2000.
A more nuanced perspective on which of the two companies is a better bargain currently would incorporate the investors time horizon. Please take a look at Table 12 which shows the current P/E relative to the historical P/E of the two companies. If you assume that reversion of the mean in terms of the P/E ratio is one component of an investor's total return, then the longer the time horizon the more likely the superior operating track record of Home Depot would dominate the wider reversion to the mean potential that Lowe's stock provides. If you make an assumption that it could take three years for a stock P/E to return to historic norms then after three years, the superior operating performance of Home Depot will likely dominate the return profile of an equally weighted two-stock portfolio.
Source: The Avg. P/E Ratio for 2015 to 2019 is taken from Tables 7 and 8.
Home Depot and Lowe's have solid operating track records and shareholder-oriented management teams. Both appear to be available at a discount to fair value and pass Buffett's test. On average, every dollar retained by Lowe's management has generated $3.23 in value and every dollar retained by Home Depot has generated $5.60 in value during the 2015 to 2019 time period. Of the two, the longer the investor's holding period is, the more Home Depot would be an appropriate consideration. Prudent investors should weigh accumulating a meaningful position.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of HD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.