How far off is The Home Depot, Inc. (NYSE:HD) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today’s value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they’re fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Home Depot

The method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:

10-year free cash flow (FCF) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$16.0b US$16.8b US$18.1b US$17.8b US$19.5b US$20.2b US$20.8b US$21.4b US$21.9b US$22.4b
Growth Rate Estimate Source Analyst x10 Analyst x9 Analyst x6 Analyst x2 Analyst x2 Est @ 3.56% Est @ 3.08% Est @ 2.74% Est @ 2.51% Est @ 2.34%
Present Value ($, Millions) Discounted @ 7.2% US$14.9k US$14.6k US$14.7k US$13.4k US$13.7k US$13.3k US$12.8k US$12.2k US$11.7k US$11.1k

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$132b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to today’s value at a cost of equity of 7.2%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$22b× (1 + 2.0%) ÷ (7.2%– 2.0%) = US$433b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$433b÷ ( 1 + 7.2%)10= US$215b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$348b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$415, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.

NYSE:HD Discounted Cash Flow January 1st 2022

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Home Depot as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we’ve used 7.2%, which is based on a levered beta of 1.205. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value lower than the current share price? For Home Depot, we’ve compiled three relevant factors you should explore:

  1. Risks: You should be aware of the 1 warning sign for Home Depot we’ve uncovered before considering an investment in the company.
  2. Future Earnings: How does HD’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

https://simplywall.st/stocks/us/retail/nyse-hd/home-depot/news/is-the-home-depot-inc-nysehd-worth-us415-based-on-its-intrin