PREFACE After the successful completion of the course named “ Investment Analysis” (F-307) of the BBA
program, preparation for the term paper provides us an opportunity to reduce the gap between the theoretical knowledge & practical experience. To enhance the analytical competence, we were given the onus to prepare a case study on Home Depot which has undoubtedly put fresh impetus to our understanding of the Stock markets, interest rates and the growth rate of the company. We tried to demonstrate the objective of the case analysis which is to illustrate the stock price valuation breakdowns and the fall of the stock price. Moreover, we attempted to portray an unbiased analysis and information about the company.
ACKNOWLEDGEMENT
First, our heartfelt gratitude should go to the Beneficent, the Merciful & Almighty Allah for giving us the strength s trength and patience to prepare this report within the scheduled time. We are deeply indebted to our course teacher, Dr. M. Sadiqul Islam, Professor, Department of Finance, University of Dhaka, for his kind cooperation and valuable contribution in preparing the report. We also like to convey our thanks to those who helped us by providing necessary information regarding the Analysis. At last, all the members of Group-04 should be acknowledged for their nice & dedicated service behind the making of the report.
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EXECUTIVE SUMMARY The purpose of this project paper is to analyze the Home Depot, which was the first to really commercialize the big-box format back in 1978. Home Depot has grown since then to become the largest home improvement retailer in the world. The Home Depot is considered one of the largest retail employers today. With the intensely competitive nature of the home improvement retail segment, it becomes vital to not only make the exact product available to the customers at the right price, but having sensitivity to serving what the customer needs will make the difference in who gains competitive advantages. Although Home Depot has delivered superb financial results since its inception, over the last six years they have encountered their share of challenges to include eroding market share to Lowes, and severe organizational discontent from shareholders, employees as well as customers with a deteriorating housing market. From the in depth analysis of Home Depot and its primary competitors, it seems that Home Depot is positioned well to move into the next millennium. Financially, Home Depot is very sound which is good considering they will need vast amounts of capital to continue growth. Home Depot also appears to be realizing investments from IT as well as operational efficiencies provided to them. They should also be careful not to grow out of control due to imminent market saturation and overall industry slowdown.
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Executive Summary
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Chapter 01 Background of the Study
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Chapter 02 Introducing Home Depot Inc.
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Chapter 03 Analysis of the Economy
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Chapter 04 Industry Analysis
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Chapter 05 Company Analysis
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Chapter 06 Problem Statement
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Chapter 07 Recommendation
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Appendix
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CHAPTER 01 B ACKGROUND
OF THE
S TUDY
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B ACKGROUND O F T H E S TUDY The Home Depot was formed in 1978 by Bernie Marcus and Arthur Blank in Atlanta, Georgia. Home Depot virtually revolutionized the do-it-yourself home improvement industry in the United States almost overnight. overnight. The two entrepreneurs opened their stores which were no frills frills warehouses. Home Depot has grown so quickly, it has been able to garner significant concessions in prices from suppliers. Home Depot was considered one of the largest retail employers that time. With the intensely competitive nature of the home improvement retail segment, it became vital to not only make the exact product available to the customers at the right price, but having sensitivity to serving what the customer needs will make the difference in who gains competitive advantages. Home Depot had also been able to establish and successfully execute a market saturation strategy coupled with low prices and high service. It had been reported that prior to the first store opening, Bernard Marcus was “so intent on creating a warehouse feel that he raced around on a forklift, throwing on the brakes to create skid marks on the floors”. The co-founders envisioned a huge warehouse store where all products would be acquired and delivered almost instantaneously from the manufacturer‟s production
floor. The hook for the customer was the promise of amazingly low prices, in an environment where the do-it-yourself customer would be assisted by knowledgeable sales people, who through their expertise, would instruct motivate and encourage customers towards what was needed to fix and improve the home environment.
O RIGIN
OF THE
R EPORT
The BBA program under the department of finance offers a course named “INVESTMENT ANALYSIS” (F-307) which requires every group to submit a report on a specific topic
determined by the course instructor. The report under the headline “Case Analysis on home Depot, Inc” has been prepared towards this purpose.
Objectives of the Study The primary objective of this study is the partial fulfillment of the course requirement. The objectives of this report are as follows: To familiarize with practical functions of Stock valuation of Home Depot. 6 |Page
To have an exposure on analysis of Stock and its fall of price. To relate the rules and regulations with the practical functions of that company. compan y. To present an overview of the financial performance of the company. To appraise the Performance of it in the stock market over time.
Scope of the Study Our honorable teacher assigned us the case and work on it. As per requirement we worked on that case to make a report on Home Depot, Inc. In this report, we work on the data regarding the financial performance of Home Depot, Inc. Here we create a overview on this sector. We only
clarify the subject matters which is relevant to our report topics assigned by our Course instructor.
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CHAPTER 02 INTRODUCING H O ME D EPOT I NC .
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I NTRODUCING H O M E D EPOT I N C . H O M E D EPOT I N C .
An American retailer of home improvement and construction products and services.
Headquartered in Vinings, just outside Atlanta in unincorporated Cobb County, Georgia,
Established in 1978 by Bernie Marcus and Arthur Blank, the Home Depot Corporation opened its first store in Atlanta, becoming the world‟s largest home improvement retailer.
They are now the second largest retailer in the United States, offering different types of home improvement supplies and building materials products.
They carry a wide assortment of low-cost products, and offer expert advice and exceptional customer service.
As an innovator of the home improvement industry, Home Depot has expanded into Canada, Mexico, Argentina, Chile, and Puerto Rico.
Home Depot caters to Do-It-Yourself customers, as well as home improvement, construction and building maintenance professionals.
Home Depot‟s stock went public in 1981 and is traded in the New York Stock Exchange.
IN 1988 Fortune magazine viewed Home Depot as “the only company that has
successfully brought off the union of low prices and high service”
At the end of 1999 it operated 930 stores, almost all of them in the US and Canada.
HISTORY OF HOME DEPOT
The Home Depot was formed in 1978 by Bernie Marcus and Arthur Blank in Atlanta, Georgia.
Home Depot virtually revolutionized the do-it-yourself home improvement industry in the United States almost overnight.
The two entrepreneurs opened their stores which were no frills warehouses. Products varied from well known national brands to propriety Home Depot brands.
Home Depot held its IPO in 1981 and listed on the New York Stock Exchange three years later.
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In 1997, however, Blank succeeded Marcus as CEO of the company, with Marcus remaining as chairman.
In 1999 Home Depot acquired a company named Georgia Lighting a specialty lighting designer, distributor and retailer.
In 1998 it opened two stores in Chile and on in Pueto Rico
P RODUCTS & & S S ERVICES
The Home Depot provides various product and services, including:
Home Improvement Goods
Rental services
Installation services
Appliances
C USTOMER S EGMENTATION Home Depot has three distinct customer segments. Since the company‟s incorporation, they have been primarily focused with the Do-It-Yourself (DIY) customers. These customers are nonprofessional consumers interested in doing their own home improvement projects. More recently, Home Depot has also begun to redefine the market in which they operate. This redefinition has opened up the buy- it-yourself and professional customer segments to Home Depot. Specifically the buy-it-yourself customer segment are those consumers that like to pick out the materials being used in their homes, but want a professional to install them. Moreover the professional customer segment that Home Depot now associates it with is contractors, electricians, plumbers, landscapers, etc. This group has been able to get Home Depot to offer products in larger quantities due to their larger scale projects. Recently they have started to serve heavy industrial sector customers. .
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CHAPTER 03 A NALYSIS
OF THE
E CONOMY
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A NALYSIS MACROECONOMIC
OF THE
E CONOMY
ANALYSIS
The macroeconomic analysis of a company is in the response to the belief that company future earnings, growth and stock prices are heavily affected by money supply, interest rates, taxing, government spending and other economic indicators such as consumer expectations, unemployment, productivity, domestic and foreign legislation, gross domestic product(GDP) growth and capacity utilization that is output by the firm. Security market also reflects what is expected to go in the economy, because the value of an investment is determined by its expected cash flows and its expected required rate of return. Both of these valuation factors are influenced by the aggregate economic environment.
ECONOMIC ACTIVITY
AND
H OME DEPOT STOCK PRICES
Stock prices consistently turn before the economy d oes. On October the company‟s stock prices
dropped to $35. The reason behind this was that stock prices reflect expectations of earnings, dividend and interest rates. As investors of Home Depot securities attempted to estimate their future variables, their stock price decisions reflect future economic activity not current and past. p ast. As Home Depot announced that their earrings will be lower for the next few quarters and there was a possibility of slowing economic activity. During the period in which Home Depot had existed, the home improvement industry in U.S. had grown at an annual rate of about 6 percent or slightly slower than the U.S. economy as a whole. But in June 2000, with expectation of some slowing in the economy, Home Depot their nominal growth will be lower over the next several years. That is why company EPS and subsequently stock price would fall down.
MONETARY
POLICY, THE ECONOMY AND STOCK PRICES
Declines in the growth rate of money supply have preceded business contraction while increases in the growth rate of money supply have consistently preceded economic expansion. The Federal Reserve controls the money supply through various tools, the most useful of which is open market operations. Since 1992 the U.S. economy had experienced consistent growth. But June 1999 and May 2000, however, the Federal Reserve had raised interest rates six times- for a total of 1.75 percentage points- in an effort to slow the economy and softening overall consumer 12 | P a g e
demand. To slow down the overall consumer demand Federal Reserve declined the growth rate money supply, Federal Reserve sold bonds to reduce banks reserves and the money supply. For the reduced money supply commercial banks got less opportunity give potential investor and home owners. Reduced money supply reduced the home ownership and discretionary income and result in weak housing turnover. During the recession of 1990-1991 Home Depot experienced only a small decline in sales, but at that point it occupied a far smaller share of the market. As Home Depot market share increased the impact of reduced money supply that is Federal Reserve step to slow down consumer demand affected the company sales that result in decline in the stock prices. As Federal Reserve planned to continue it next several there is a possibility of declining hosing owner ship and discretionary income that will significantly reduce the EPS, growth and with a low expectations of dividend stock prices will decline as well.
INFLATION,
INTEREST RATES AND STOCK PRICES, GROWTH, EARNINGS
The relationship between inflation, interest rates and stock prices is not direct and consistent. The reason is that the cash flows from stocks can change along with inflation and interest rates and we cannot be certain whether this change in cash flows will augment or offset the change in the interest rates. Inflation and interest rates had very negative impact on Home Depot stock prices, growth and earnings. A recent rise of inflation that was result in an increase in interest rates was caused to decline cash flows because the inflation that caused the rise in interest rates had a negative impact on earnings. During 1999 and 2000, interest rates increased and that caused economic decline and sales and earnings to decline. On the other hand a period of inflation wherein the costs of production increased, but Home Depot was not able to increase prices, which caused a decline in profit margins. The impact of this set of event was become more disastrous when stock prices had experienced a significant decline because k increased as g declined, causing a large increased in the k-g spread. In future Home Depot can make the scenario with an increase in prices of its products for additional cost due to inflation. In this case, stock prices might be fairly stable because negative effect of an increase in the required rate of return (k) is partially or wholly offset by the increase in the growth rate of earnings and dividends(g), which means that the return on stock increase in line with the rate of inflation.
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OTHER DEPOT
E C O N O M I C I N D I C A T O R S A N D I T S P O T E N T I A L I M P A C T ON ’
S GROWTH
HOME
& P R O F I T
Home Depot currently has limited scale foreign operation but company‟s plan to increase its
international operation could be seriously affected by foreign country economic framework as well as potential currency exchange risk. Future unemployment problems can decrease as well as increase the company‟s overall growth rates.
Productivity of labor can also be a good example potential growth or decline. GDP can play a significant role in future growth and earnings. Future growth and prospect will also be increased if Home Depot able ab le to utilize its full capacity.
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CHAPTER 04 I NDUSTRY A NALYSIS
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I NDUSTRY A NALYSIS The industry to which Home Depot Inc. belongs to expects the following growth rates over the years 2000 to 2004:
Year
Projected Growth in the US Market for Home Improvement Products
2000
6.3%
2001
3.2%
2002
4.0%
2003
4.4%
2004
4.6%
Projected Growth in the US Market for Home Improvement Products 7.00% 6.00% 5.00%
Projected Growth in the US Market for Home Improvement Products
4.00% 3.00% 2.00% 1.00% 0.00% 2000
2001
2002
2003
2004
The US retail industry for home improvement products show a cyclical pattern as the stock prices were low throughout the year 2000 whose primary reason is considered to be the slowing US economy. It means the retail industry for home improvement products moves with or follows the economic trend of the US economy resulting in the cyclical pattern of the industry.
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I NDUSTRY A NALYSIS
OF
H O M E D EPOT I N C .
IN THE
P ORTER ’ S F I V E
F ORCES F RAMEWORK : Porter‟s Five Forces model can be used as a tool to analyze the industry of Home Depot, Inc.
Five Forces Analysis assumes that there are five important forces that determine competitive power in a business situation. These are:
The Threat of The Entry of New Competitors Co mpetitors
The Intensity of Competitive Rivalry
The Threat of Substitute Products or Services
The Bargaining Power of Customers (Buyers)
The Bargaining Power of Suppliers
These forces are used to analyze the US retail home improvement products industry:
THE THREAT
OF
THE ENTRY OF NEW COMPETITORS
Home Depot Inc. the largest retailer of home h ome improvement products in the United States possesses almost 24 percent of the total market share of home improvements product. Home Depot operated 930 stores spread over United States and Canada and has plans to reach the target of having over1900 stores by the end of 2003. Recent data suggests that the recently opened stores were in the existing markets to increase customer service levels and enhance long term market penetration. Home Depot‟s principal competitor Lowe‟s competitor Lowe‟s had 576 stores at the end of o f
1999 and planned to add 78 new ones in 2000 in the existing market. So the competition in the home improvements products‟ market was high. In this situation it is quite difficult for a new
entrant to capture the market. A new entrant must have extremely strong competitive advantage to penetrate the market to which Home Depot belonged. So, for Home Depot Inc. threat of the entry of new competitors was fairly low.
THE INTENSITY OF COMPETITIVE RIVALRY The competition that Home Depot Inc. faces is quite intense. Lowe‟s is considered to be the principal competitor of Home Depot Inc. having $16 billion as annual sales. At the end of 1999 Lowe‟s was operating 576 stores and had plans to open 78 new ones in 2000. Lowe‟s is the 17 | P a g e
second largest home improvement retailer in the world just b ehind Home Depot Inc. Lowe‟s copied Home Depot‟s business model and made its stores more attractive to the customers. Lowe‟s also sold many products which Home De pot was not offering. In certain markets Lowe‟s
was competing neck to neck with Home Depot and opened a few stores within the virtual eye sight of Home Depot‟s stores creating much difficulty for them to sell their products.
Menards and HomeBase a firm that was more focused geographically was considered to be the next largest competitor of Home Depot although it was a far smaller company. Menards and HomeBase had a loyal customer base that allowed it to have 35% of the market share of the home improvement products whereas Home Depot had only 15% in certain areas in the year 1998. Although Home Depot is the market leader in terms of having the competitive advantage of implementing a successful business model, its competitors follow them quickly eliminating its competitive edge over its competitors. It indicates an intense competitive rivalry in the US retail home improvement products‟ industry. Home Depot Inc. has less bargaining power over its
competitors as it was facing a tough tou gh fight from its competitors.
THE THREAT
OF
SUBSTITUTE PRODUCTS
OR
SERVICES
Home Depot provides its customers cus tomers with best quality products at a relatively competitive price. Home Depot‟s core products are home improvement products. As long as there are homes,
improvements will be needed. Substitute of home improvement products can be if people stop improving their homes and start purchasing new homes instead. But this is a very rare possibility. For Home Depot Inc. the threat of substitution is not a huge factor.
THE BARGAINING POWER
OF
CUSTOMERS (BUYERS )
Customers had a huge role in the products that Home Depot offered. Every time Home Depot wanted to introduce a new product or service, it was done as an experiment to check the reaction om the of the customers. Home Depot‟s main concern was always the customer needs. Starting fr om products they designed to the store format was decided on the basis of customer needs and reaction to experiments. To serve the customer needs it changed its strategy of serving only nonprofessionals to a triple customer strategy which included installation services and serving professionals as well as nonprofessionals. To mitigate the need of the customers it also plans to 18 | P a g e
introduce Internet Sales. So, the customers have a great impact on the operating style and decisions of Home Depot Inc. Home Depot planned to expand its business in the same market and for this reason the customer cu stomer group concentration was limited within that market. It enabled the customers to have more impact on Home Depot‟s activities. The customers‟ bargaining
power is higher.
THE BARGAINING POWER
OF
SUPPLIERS
Home Depot is the largest retailer of home improvement products and possesses a huge portion of total market share. As such suppliers of Home Depot largely depend on them. To be more efficient, Home Depot acquired two firms of its suppliers. To provide Installation services Home Depot arranged for approximately 6,200 third party p arty contracts for which it collected fees. So, S o, Home Depot has a greater bargaining power over its suppliers. The next section summarizes the US retail home improvement products industry to which Home Depot belong, in the Porter‟s Five Forces Framework.
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U S R ETAIL H O M E I MPROVEMENT P RODUCTS I NDUSTRY IN T H E P ORTER ’ S F I V E F ORCES F RAMEWORK :
Less Threat of The Entry of New Competitors
Less Bargaining Power of Suppliers
High Bargaining Power of Customers
US Retail Industry for Home Improvement Products
HighIntensity of Competitive Rivalry
Less Threat of Substitute Products or Services
This graphical illustration indicates that competitive rivalry and customers‟ bargaining power pose grave threat to the industry, while other three factors pose less les s threat to this industry.
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CHAPTER 05 C OMPANY A NALYSIS
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C OMPANY A NALYSIS SWOT A NALYSIS Analysis of a company includes the anal ysis of the company‟s internal and external factors. To
analyze these factors SWOT analysis is used. SWOT Analysis of Home Depot Inc. illustrates the strengths, weaknesses, opportunities and threats of the company.
SWOT
ANALYSIS OF
H O M E D EPOT I N C .
STRENGTHS The Home Depot brand name n ame itself is a significant strength.
Home Depot controls approximately 20% of the home improvement market.
Customer Satisfaction
Innovation
Financial Stability
Economies of Scale
Leadership
Stable Cash Flow
WEAKNESSES
Stores are not geared toward attracting female customers, cus tomers, who make most
Household buying decisions
Declining stock prices
Rising costs
OPPORTUNITIES
Untapped heavy industrial sector
North American growth potential
Service sector
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THREATS
Slowing economy
High interest rates
Potential lower industry growth rate
G RAPHICAL I LLUSTRATION
OF
SWOT A NALYSIS
Strengths Brand name
Weaknesses
Innovation
Inattractive Stores
Leadership
Declining stock prices
Stable cashflows
Increased costs
Economics of scale Customer satisfaction
SWOT ANALYSIS
Opportunities Untapped heavy industrial sectors North American growth potential Huge service sectors
Threats Economic Slowdown High Interest Rates High Competition
International Expansion
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ESTIMATING GROWTH COMPANY
GROWTH RATE
Dividend share (1)
(2)
Dividend payout ratio (3)=(1)/(2)
1999
0.1088
1.00
0.1088
0.891119
.265
0.236146
1998
0.0724
0.71
0.1019
0.898009
.227
0.203848
1997
0.0607
0.52
0.1168
0.883119
.195
0.172208
DIVIDEND
per Earnings per share
Retention ratio
ROE
Growth
(4)=1-(3)
(5)
(6)=(4)*(5)
GROWTH RATE
Let assume, D0= $139 million dividend in 1998 and D2=$ 255 million dividend in 2000. By using the formula we get the average dividend growth rate is 35.44%.
√
IMPACT OF THE GROWTH INITIATIVE ON COMPANY’ S CUSTOMER
GROWTH RATE
G R O U P S:
Buy-it-Yourself Customers:
Key points of this customer group are summarized below:
These people choose Products but Installed by Third-Party
6,200 third-party contractors is arranged by the company
Aging demographics creating opportunity for market expansion.
Market for installation services estimated at $75 bi llion.
Less than 2% of the installation market.
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Expected to grow by 40% each year for the next five years.
The initiative of increasing number of services offered to the buy it yourself customers will be having positive impact of growth rate. As the market size for installation services is large and this customer segment is less exposed to cyclical changes, it will definitely have a positive impact on growth rate.
Professional Customers:
Key points of this customer group are summarized below:
Large Market potential
„Job Lot‟ quantities
Different needs for different customers
Effect of professional customers on DIY
Anticipated to influence sales the most out of all of the initiatives
More cyclical then DIY business
Expanding market share for professional customers unveiled another opportunity for the company. This market emerges as the most profitable and largest market. Unique strategy is needed to capture this market and cyclical characteristics will set challenges before the company. Nevertheless this market segment will have positive impact on the company growth rate.
STORE FORMATS Key points of this customer group are summarized below:
Extending into specialty shops
Very high end product range
Required retainer fee
Sales goal for each customer ($10,000)
Investigating smaller stores to compete more directl y with Home Hardware etc. 25 | P a g e
The store format home depot Inc is experimenting do not fully compatible with current business plan and strategy. Two focused customer group cannot be well served with such store formats. Maintenance cost of Expo design center stores will be higher than others warehouse stores. Again economy is supposed to be slowdown. It will lead the customers choosing products which costing lower. On the other hand direct competitions can slower the sales potentiality of the small stores.
PRODUCT CATEGORIES Key points of this customer group are summarized below:
Increasing product lines
Adding appliances to complement current offerings
Vertically integrate supply chain
Tool rentals and truck rentals
Expansion of rental services and current offering of appliances definitely make the Home depot Inc an affectionate destination for shopping having positive effect on firm‟s growth rate.
INTERNATIONAL GROWTH Key points of this customer group are summarized below:
Expansion into South America
Joint venture in Chile
Looking into expansion into the Far East
Entering into international market will make the firm more exposed to the exchange rate risk. Again differences in culture and customer needs will create more difficulties in managing venture and create a strong position in market.
INTERNET SALES Key points of this customer group are summarized below:
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Information centre for customers
Adding e-commerce abilities
Intended to complement brick stores
Extending business operations through internet will dignify the corporate image and facilitate customers with pre shopping information. Along with raising operational cost it will have a positive impact on the growth rate.
SALES FORECAST Year
AND
NOPAT
Sales
GROWTH RATE
Sales growth
NOPAT
NOPAT growth
2000
42563.45
0.262369
2511.111
0.429385
2001
48392
0.136938
2918
0.162035
2002
54220.56
0.120445
3324.889
0.139441
2003
60049.11
0.107497
3731.778
0.122377
2004
65877.67
0.097063
4138.667
0.109034
2005
71706.23
0.088475
4545.555
0.098314
2006
77534.78
0.081284
4952.444
0.089514
2007
83363.34
0.075173
5359.333
0.082159
To forecast sales and NOPAT we use double moving average technique. By analyzing data we can conclude that there is a possibility of declining growth rate of earnings in future. Again, we can say that this is the state of the firm which induced indu ced the firm to take growth initiatives to increase its company growth rate. Considering Co nsidering the initiative taken by the firm we expect the firm will be enabling to achieve a greater growth rate then our forecasted value. So, here we are considering these values as the minimum rate which can be attained by the firm even without any growth initiatives.
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S UMMARY O F T H E O BSERVATION Growth initiatives
Impact on earnings growth
Impact on stock price
Customer groups
+
+
Store Formats
-
-
Product Categories
+
+
International Growth
+
+
Internet Sales
+
+
Growth rate Average dividend growth rate
35.44%
Simple Annual sales growth rate
32.45%
Simple Average NOPAT growth
40.53%
Current company growth rate
23.61%
Growth range for year 2000
23.61% to 35.44% and declining there after
ESTIMATED GROWTH R ATE ATE After considering all the facts mentioned, we are expecting a moderate earnings growth rate over the next few years because of a slow economy. Again we assume that effect of competitive advantages and the growth initiatives will be sustaining for a definite time period. As a result in absence of any new strategy growth rate will be declining in later years. For our valuation purpose we assume that the growth will remain unchanged for the years afterward.
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Year
Growth rate (%) Normal
Optimistic
Pessimistic
2001
24
25
22
2002
24
25
22
2003
24
25
22
2004
24
25
21
2005
24
24
21
2006
23
24
19
2007
22
24
18
2008
21
23
17
2009
18
20
16
2010
16.5
17
16
A SSUMPTIONS OPTIMISTIC Affirmation
Negation
Favorable industry growth because of Low
Rise in Federal Reserve interest rate.
interest rate, strong housing turnover, rising
Slowdown in economy and squeeze
home ownership and increases in discretionary income.
Continued growth with Do It Yourself Business
Successful expansion of stores and product
in consumer spending.
High competition.
categories will lead toward a high sales volume.
40% growth in Buy It Yourself Customers.
Growth with Professional Customers with high margin.
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As interest rate on mortgage loan is low, it is creating a favorable market condition for Home Depot. We are also expecting a rise in growth rate in later years. As both the average dividend and NOPAT growth is higher, it implies having a high growth rate potentiality in future. A gain, company is planning to add new stores. Market of home depot products is growing too. This favoring external situation will help to implement their growth strategies more accurately. When starting phase of the growth initiatives lead the growth rate rising, expansion of these strategy and their ending result must be ameliorating. The company will be able to expand market share and capture more and more customers. All these fact will lead earning growth rate raising later future.
MOST
LIKELY
Affirmation
Negation
Slow economy will slow down the
Difficult to manage.
company growth rate, less so with
High probability of reduction in
Professional customers.
employee quality and customer
Some success with in Buy it Yourself
satisfaction.
Customers.
Extension of products, services, and
Higher cost of capital due to rise in interest rate.
stores- allows some growth with the Do it Yourself Customers.
PESSIMISTIC Affirmation
Some continued growth with Do It Yourself
Negation
Sustaining competitive
Business via store expansions & bundling.
advantage due to differentiation
Moderate success in Buy it Yourself
strategy.
Customers.
Difficult to cross over with the Professional Customer base.
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As a growth company, home h ome depot will keep growing in future. It is following differentiation strategy, which enables it to maintain its strong position in market. But as the economy will be in squeezed position over next few years, company will be unable to attain a higher growth rate. And later competitors will imitate their strategy lowering their market share. Cons idering this fact the growth rate will be even lower in future.
PROBABILITY OF OUTCOMES Considering all possible situation we assigned the following weights to the possible outcomes. Optimistic
.3
Most likely
.6
Pessimistic
.1
RATE
OF RETURN
Risk free rate of return(RFR)
6.18% (yields on 90 day treasury securities)
Home Depot‟s beta(β)
1.09
Market return(Rm)
16.39% GM of last 9 year S&P 500 return on stock
CAPM
MODEL E(R) = RFR + β (R m- RFR)
Using this model we got the following estimations: Market Risk premium
10.21%
(Rm- RFR)
Risk premium
11.13%
β (R mm- RFR)
Expected rate of return(k)
17.31%
RFR + β (R mm- RFR)
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ASSIGNING WEIGHTS WACC Cost of equity (K e)
17.31%
Cost of debt (Kd)
4.8% mortgage interest rate in fall after tax
Weight (We)
.92
Weight (Wd)
.08 (long term debt + capital lease)
Tax
40%
WACC
16.31
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Stock valuation
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PRESENT VALUE OF DIVIDENDS MODEL (DDM) Applying the DDM model with the values of g, k and D estimated in previous section, here we estimate the stock price of stock price of Home Depot for year 2000. dividend in year 1999 is considered as D0.
M OST
LIKELY OUT COMES
Here, D0 = $0.1089, k= 17.31%, and the estimated most likely growth rates are considered as values for g.
Year
D
g
Dividend per share Present value factor17.31% Present value
2001
1
0.24
0.133947
0.852442
0.114182
2002
2
0.24
0.166094
0.726658
0.120694
2003
3
0.24
0.205957
0.619434
0.127577
2004
4
0.24
0.255387
0.528032
0.134852
2005
5
0.24
0.316679
0.450116
0.142543
2006
6
0.23
0.389516
0.383698
0.149456
2007
7
0.22
0.475209
0.327081
0.155432
2008
8
0.21
0.575003
0.278817
0.160321
2009
9
0.18
0.678503
0.237676
0.161264
2010
10
0.165
0.790457
0.202605
0.16015
Constant growth period value =
22.9351
1. Present value of dividends $1.426470012 2. Present value of constant growth period dividends $22.9351 Total present value of dividends $24.36157 34 | P a g e
O PTIMISTIC
OUTCOMES
Here, D0 = $0.1089, k= 17.31%, and the estimated optimistic growth rates are considered as values for g.
Year
D
g
Dividend per share Present value factor17.31% Present value
2001
1
0.25
0.136125
0.852442
0.116039
2002
2
0.25
0.170156
0.726658
0.123645
2003
3
0.25
0.212695
0.619434
0.131751
2004
4
0.25
0.265869
0.528032
0.140387
2005
5
0.24
0.329678
0.450116
0.148393
2006
6
0.24
0.4088
0.383698
0.156856
2007
7
0.24
0.506912
0.327081
0.165801
2008
8
0.23
0.623502
0.278817
0.173843
2009
9
0.2
0.748203
0.237676
0.17783
2010
10
0.17
0.875397
0.202605
0.17736
Constant growth period value =
66.93897
1. Present value of dividends $1.511905 2. Present value of constant growth period dividends $66.93897 Total present value of dividends $68.45088
35 | P a g e
P ESSIMISTIC
OUTCOME
Here, D0 = $0.1089, k= 17.31%, and the estimated pessimistic growth rates are considered as values for g.
Year
D
g
Dividend per share Present value factor17.31% Present value
2001
1
0.22
0.132858
0.852442
0.113254
2002
2
0.22
0.162087
0.726658
0.117782
2003
3
0.22
0.197746
0.619434
0.12249
2004
4
0.21
0.239272
0.528032
0.126343
2005
5
0.21
0.28952
0.450116
0.130318
2006
6
0.19
0.344528
0.383698
0.132195
2007
7
0.18
0.406544
0.327081
0.132973
2008
8
0.17
0.475656
0.278817
0.132621
2009
9
0.16
0.551761
0.237676
0.13114
2010
10
0.16
0.640043
0.202605
0.129676
Constant growth period value =
11.48273
1. Present value of dividends $1.268791 2. Present value of constant growth period dividends $11.48273 Total present value of dividends $12.75152
36 | P a g e
E XPECTED
SHARE PRICE
Outcomes
Probability
Share Price
Most Likely
0.6
24.36157
14.61694
Optimistic
0.3
68.45088
20.53526
Pessimistic
0.1
11.48273
1.148273
Expected Share Price 36.30047
P RESENT
VALUE OF FREE CASH FLOW TO EQUITY
This techniques attempts to determine the free cash flow that is available to the stock holders after payments to all other capital suppliers and after providing for the continued growth of the firm. Definition of free cash flow to equity (FCFE) is:
Net income + Depreciation expense - capital expenditure e- change in working capital - principal debt payments + new debt issues
Value =
Here, we applied the formula assuming assu ming super normal growth rates estimated earlier. FC FE in period 2000 was $ 409 million. So, stock price = present value of cash flows/number of shares.
M O S T L IKELY O U T C OMES Here, FCFE0 = $409 million, k= 17.31%, and the estimated most likely growth rates are considered as values for g.
Year
Period
Growth rate FCFE
Present value factor17.31% Present value
2001
1
0.24
507.16
0.852442
432.3246
2002
2
0.24
628.8784
0.726658
456.9794
37 | P a g e
2003
3
0.24
779.8092
0.619434
483.0402
2004
4
0.24
966.9634
0.528032
510.5872
2005
5
0.24
1199.035
0.450116
539.7051
2006
6
0.23
1474.813
0.383698
565.883
2007
7
0.22
1799.271
0.327081
588.5067
2008
8
0.21
2177.118
0.278817
607.0183
2009
9
0.18
2569
0.237676
610.5887
2010
10
0.165
2992.885
0.202605
606.3727
Constant growth period value =
87212.86 million
1. Present value of cash flows 2. Present value of constant growth growth period cash flows Total present value of cash flows million Stock price
$ 5401.006 million $ 87212.86 million $ 92613.86763
$ 39.54478
O PTIMISTIC O UTCOMES Here, FCFE0 = $409 million, k= 17.31%, and the estimated optimistic growth rates are considered as values for g.
Year
Period
Growth rate FCFE
Present value factor17.31% Present value
2001
1
0.25
511.25
0.852442
435.8111
2002
2
0.25
639.0625
0.726658
464.3797
2003
3
0.25
798.8281
0.619434
494.8211 38 | P a g e
2004
4
0.25
998.5352
0.528032
527.2581
2005
5
0.24
1238.184
0.450116
557.3267
2006
6
0.24
1535.348
0.383698
589.1102
2007
7
0.24
1903.831
0.327081
622.7062
2008
8
0.23
2341.712
0.278817
652.9099
2009
9
0.2
2810.055
0.237676
667.8816
2010
10
0.17
3287.764
0.202605
666.1166
Constant growth period value =
251405.3 million
1. Present value of cash flows 2. Present value of constant growth period cash flows flows Total present value of cash flows Stock price
P ESSIMISTIC
$ 5678.321 million $ 251405.3 million million $ 257083.6 million $ 109.771
OUTCOME
Here, FCFE0 = $409 million, k= 17.31%, and the estimated pessimistic growth rates are considered as values for g.
Year
Period
Growth rate FCFE
Present value factor17.31% Present value
2001
1
0.22
498.98
0.852442
425.3516
2002
2
0.22
608.7556
0.726658
442.357
2003
3
0.22
742.6818
0.619434
460.0422
2004
4
0.21
898.645
0.528032
474.5129
2005
5
0.21
1087.36
0.450116
489.4388
39 | P a g e
2006
6
0.19
1293.959
0.383698
496.4898
2007
7
0.18
1526.872
0.327081
499.41
2008
8
0.17
1786.44
0.278817
498.0903
2009
9
0.16
2072.27
0.237676
492.5281
2010
10
0.16
2403.833
0.202605
487.0281
Constant growth period value =
43126.15 million
1. Present value of cash flows 2. Present value of constant growth period cash flows flows Total present value of cash flows Stock price
$ 4765.249 million $ 43126.15 million $ 47891.4 million $ 20.44893
E XPECTED SHARE PRICE Outcomes
Probability
SP
E(SP)
Normal
0.6
39.54478
23.72687
Optimistic
0.3
109.771
32.93129
Pessimistic
0.1
20.44893
2.044893
Expected Share Price
58.70305
40 | P a g e
S UMMARIZATION
OF THE VALUATIONS :
E STIMATED
Present value of dividends
Present value of FCFE
$ 36.30
$58.703
STOCK PRICE
Market price
$35
The market price of stock of Home Depot Inc currently is $35 while the PV of Dividends is estimated to be $ 36.30. The Present Value of FCFE is $ 58.703. It is the amount that Home Depot can afford to pay as dividend per share. It indicates that the expected dividend payment from the stocks of Home Depot Inc. is higher than the current market price. So, currently the stock of Home Depot is undervalued and the stocks seem to be growth stocks. It will be a wise decision for the investors to purchase the stocks of Home Depot now.
RELATIVE
VALUATION TECHNIQUES Earnings ($ millions)
Cash flow($ millions) Sales($ millions)
Values in 1999
2320
168
38434
Estimated values in 2000
2879.12
208.488
47696.59
Values per share
1.23
.089
20.37
P/E ratio
P/CF2000
P/S2000
Present value of dividends
29.5122
407.7674
1.782404
Present value of FCFE
47.74797
659.4261
2.882437
R ELATIVE
VALUATION RATIOS
41 | P a g e
P/E Ratio measures the price paid for a share relative to the annual net income or profit earned by the firm per share. The P/E ratio of Home Depot Inc. Inc. calculated based on the PV of dividends is 29.5122. It is estimated that Home Depot‟s earnings to be 29.5122
times its share price. While P/E ratio based on the PV of FCFE is 47.74797 indicating the earnings to be 47.74797 times the share price. Home Depot‟s shares have a very high P/E. Investors can expect a high future growth in earnings.
P/CF ratio is a ratio used to compare a company's market value to its cash flow. The P/CF ratio calculated based on PV of Dividends is 407.7674 and P/CF calculated based on PV of FCFE is 659.4261. The P/CF is similar to a company's P/E ratio, but it does not take into account earnings that have not actually been received. P/CF ratio allows its users to assess risk relative to the company's cash on-hand, instead of the cash it ought to have. When compared to P/CF ratios of other firm, the lower the P/CF is, the better bett er value that stock is.
P/S ratio is the ratio of a stock's price to its per-share sales. This ratio is used to find whether a stock's current market price is expensive or cheap. A low price to sales ratio ratio (below 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. The P/S ratio based on PV of Dividends of Home Depot is 1.78 and P/S ratio calculated based on PV of FCFE is 2.88. The P/S ratio of Home Depot is higher than one. But whether investment in Home Depot‟s share is good or not must be decided
by comparing the P/S ratio of other firms in the same industry.
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D U P O N T A NALYSIS The return on investment (ROI) ratio is used by many firms to evaluate how effectively assets are used. The ROI of Home Depot Inc. for the year 2000 is:
=0.1185 The return on equity (ROE) ratio is a measure of the rate of return to stockholders. stock holders.Du Du Pont Analysis decomposes the ROE into various factors influencing company performance. The ROE of Home Depot Inc. for the year 2000 is:
=0.2034 Where, Net profit = net profit after taxes Equity = shareholders' equity EBIT = Earnings before interest and taxes Sales = Net sales
43 | P a g e
R ATIO A NALYSIS
Profit Margin or Net Profit Ratio: a measure of profitability calculated by finding the net profit as a percentage of the revenue. The profit margin is mostly used for internal comparison. The profit margin ratio of Home Depot Inc. in 2000 is:
Home Depot Inc. has a net income of 0.714 dollars for each dollar of sales.
Asset Turnover Ratio: a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company. Asset Turnover ratio is calculated by dividing average total assets by net sales. The asset turnover ratio of Home Depot Inc. for the year 2000 is:
Home Depot has an asset turnover ratio of 2.25 which is high indicating a low profit margin because of competitive pricing.
Leverage Ratio: measures a company‟s ability to meet its financial obligations. The leverage ratio of Home Depot Inc. in the year 2000 is:
Home Depot‟s Leverage ratio is 1.72.
44 | P a g e
R I S K A NALYSIS ME ASURE S OF RI S K
R ANGE
OF GROWTH
Range = optimistic outcome – pessimistic out come Year
Optimistic growth rate Pessimistic growth rate Range
2001
0.25
0.22
0.03
2002
0.25
0.22
0.03
2003
0.25
0.22
0.03
2004
0.25
0.21
0.04
2005
0.24
0.21
0.03
2006
0.24
0.19
0.05
2007
0.24
0.18
0.06
2008
0.23
0.17
0.06
2009
0.2
0.16
0.04
2010
0.17
0.16
0.01
In the table above growth can vary year to year by range mentioned in the last column.
S TANDARD
DEVIATION
1
Standard deviation is a measure of the variation of possible outcomes from the expected outcomes. The larger the standard deviation, the greater the dispersion of expected outcomes and the greater the uncertainty. In the table below we have shown standard deviation for the forecasted values for earnings, cash flow and sales. Earnings ($ millions)
Cash flow ($ millions)
Sales ($ millions)
541.14
39.42
8964.80
B ETA 1
VALUE
Calculations are shown in appendix
45 | P a g e
Beta represents the covariance of returns with the market portfolio. Here company beta b eta = 1.09. it indicates that if market return increases by 1%, compan y‟s return will increase by 1.09% and
vice versa.
S ENSITIVITY
ANALYSIS
In this section we will a nalyze company‟s stock price sensitivity toward change in some input variables. Variables to be changed:
Required rate of return Dividends Free cash flow to equity
CHANGE IN DIVIDEND In the table below, changes in stock price using Dividend Discounting Model due to changes in amount of dividend to stock holders. Dividend per share ($)
Stock price($) PV OF DDM
P V O F FCFE
Base case
0.1088
36.30
58.703
increase
0.12
40
58.703
Decrease
0.08
26.67
58.703
SENSITIVITY TOWARD STOCK PRICE DUE TO CHANGE IN DIVIDENDS
INTERPRETATION: IF THE DIVIDEND INCREASES BY WILL INCREASE BY
$1,
COMPANY‟S STOCK PRICE
$330.36
46 | P a g e
CHANGE
IN REQUIRED RATE OF RETURN
R E Q U I R E D R A T E O F
STOCK PRICE ($)
RETURN
BASE
PV OF DDM
P V O F FCFE
17.31%
36.30
58.703
18%
15.72
48.42
CASE
INCREASE
SENSITIVITY TOWARD STOCK PRICE DUE TO CHANGE IN REQUIRED RATE OF RETURN
=
PV of DDM
PV of FCFE
INTERPRETATION : CHANGE IN REQUIRED RATE OF RETURN WILL AFFECT BOTH OF THE PRICES.
IF
THE REQUIRED RATE OF RETURN INCREASES BY
PRICE WILL DECREASE BY
$2982.61
1%,
COMPANY‟S STOCK
USING THE DDM MODEL AND
$1489.86
USING
THE FCFE MODEL.
CHANGES
IN FREE CASH FLOW TO EQUITY
FREE CASH FLOW TO EQUITY
STOCK PRICE ( $)
( $) PV OF DDM
P V O F FCFE
BASE CASE
409
36.30
58.703
INCREASE
489
36.30
70.19
DECREASE
289
36.30
41.48
47 | P a g e
SENSITIVITY TOWARD STOCK PRICE DUE TO CHANGE IN FREE CASH FLOW TO EQUITY
=
= 0.1436
INTERPRETATION: IF THE FREE CASH FLOW TO EQUITY INCREASES BY COMPANY‟S STOCK PRICE WILL INCREASE BY
C HANGE CHANGE
$1,
$0.1436.
IN GROWTH RATE
IN COMPANY ‟S ESTIMATED GROWTH RATE CAN CHANGE THE STOCK PRICE
DRASTICALLY.
A
SLIGHT CHANGE IN GROWTH RATE AT YEAR
2010
CAN CHANGE
S T O C K P R I C E T O A G R E A T E X T E N T.
Company’s stock price is more sensitive towards growth rate and required rate of return.
SOURCES OF RISK B USINESS
RISK
Business risk is the uncertainty of income flows caused by th e nature of a firm‟s business. In the
previous section calculation of standard deviation of earnings and sales has been shown. The large values indicate that, there are large variations in estimated earnings and sales. So the firm is operating a high business risk.
F INANCIAL
RISK
Financial risk is the Uncertainty caused by the use of debt financing. As in current year firm is operating at 17% financial leverage, we can say that the financial risk for the firm is moderate. If the proportion of debt capital increases, firm‟s financial risk will increase as well.
48 | P a g e
E XCHANGE
RATE RISK
Exchange rate risk is Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor. As the th e firm is planning for expansion in foreign market, exchange rate risk will increase.
C OUNTRY
RISK
The U.S economy had experienced uninterrupted growth since 1992. Assuming a stable political state, firm‟s exposure to country risk is lower.
49 | P a g e
CHAPTER 06 P ROBLEM S TATEMENT
50 | P a g e
POTENTIAL PROBLEMS OF THE COMPANY N EGATIVE OPERATING FREE CASH FLOW The object is to determine a value for the total firm and subtract the value of the firm‟s debt obligations to arrive at a value for the firm‟s equity. Operating free cash flow = EBIT (1-tax rate) + Depreciation expense - capital expenditure – change in other asset change in working capital capital –
While free cash flow doesn't receive as much media coverage as earnings do, it is considered by some experts to be a better
Calculation of OFCF EBIT (1-tax rate)
2299.2
flow is not necessarily an indication of a bad company,
Add : depreciation
463
however, since many young companies put a lot of their cash
expense
indicator of a company's financial health. Negative free cash
into investments, which diminishes their free cash flow. But if a company is spending so much cash, it should have a good
less: capital
-2581
expenditure
reason for doing so and it should be earning a sufficiently high rate of return on its investments. As the firm is expected
less: change in
to earn a high rate of return on investment, there is higher
working capital
probability of positive OFCF in near future.
OFCF
-301
-119.8
H IGH OPERATING LEVERAGE At the end of 1999 the company owned 77% of its store and leased 23% of them. Again the company planned to increase proportion of owned stores. This will cause rise in fix cost and a high operating leverage. By leasing the store firm can reduce its operating leverage and there by the operational risk.
51 | P a g e
CHAPTER 07 R ECOMMENDATION
52 | P a g e
R ECOMMENDATION Management of risk is important. But It is also important to choose cost effective approaches. If the cost to eliminate the risk is higher than the potential loss, there is no point in spending more to eliminating a risk. Often, it may be better to accept the risk than to use excessive resources to eliminate it.
R ISK MAY BE MANAGED IN A NUMBER OF WAYS
BY
USING EXISTING ASSETS :
Here existing resources can be used to counter risk. This may involve improvements to existing methods and systems, changes in responsibilities, improvements to accountability and internal controls, etc.
BY
CONTINGENCY PLANNING:
Home Depot may decide to accept a risk, but choose to develop a plan to minimize its effects if it happens. A good contingency plan will allow Home Depot to take action immediately, with the minimum of project control if Home Depot finds them in a crisis management situation.
BY
INVESTING IN NEW RESOURCES :
Home Depot risk analysis gives it the basis for deciding whether to bring in additional resources to counter the risk. This can also include insuring the risk: Here they may pay someone else to carry part of the risk.
53 | P a g e
