Valuation

VALUATION: HOME DEPOT

IBMS 4c

CERTIFICATION OF AUTHORSHIP:
I hereby certify that I am the author of this report. All assistance I have received from
outside sources have been documented in the report, as well as, listed after the
conclusion under “Bibliography”. This report was created exclusively by me specifically
for the course ‘Valuation’ at The Hague University of Applied Sciences.

Pablo Horcasitas 14027976

Metin Zdralla 13118420
Prepared for:

Mr.Huibers

March 19, 2018 0

Contents
WACC calculations ........................................................................................................................................ 2
Computation of the Capital Weights ........................................................................................................ 2
After-tax cost of debt ............................................................................................................................ 2
Cost of Preferred Stock ......................................................................................................................... 2
The Cost of Common Equity ......................................................................................................................... 3
Compute Market Return ........................................................................................................................... 3
WACC Sensitivity Analysis ............................................................................................................................. 5
Market Assessment ...................................................................................................................................... 0
Bibliography .................................................................................................................................................. 1

March 19, 2018 1

 WACC calculations
Computation of the Capital Weights
For this calculation we used the book values and market values for Home Depot to compare results.

Step 1: Compute Capital Weights

BV
Liabilities + Equity Book Values (BV) Weights Market Values (MV) MV Weights
Long Term Debt & Other Non-
Current Liabilities $ 24.204,00 71% $ 25.625,99 10,953%
Common Equity $ 9.875,00 29% $ 208.341,90 89,047%
Totals $ 34.079,00 100% $ 233.967,89 100%

Market value for liabilities was calculated by sum of five years’ average value of notes payable and market
prices of five issues bonds by Home Depot. Common equity market value is current market capitalization.

As it can be seen in the table above, the difference between BV weights and MV weights is extremely
significant. The difference between book values per share and current shares price is the reason why there
is a significant difference between BV weight and MV weight. Since market value of equity represents
company’s value fairer than book value, for our future calculations we will use weights of market values.

After-tax cost of debt

According to Market Insider the most recent issued bond has an 3,5% interest rate. In order to
make this research more logical and realistic, we suggest to 3,5% YTM as the shortest and the
most recent one. Furthermore, the percentage that is being used for our further calculations does
not differ considerably from the average YTM.

Tax Rate (Historical Average) is 36,45%

After-Tax cost of debt = 3,5% * ( 1- 36,45%) = 2,22%

To get the After-Tax cost of debt, we calculated the most recent YTM multiplied by the difference of one
minus tax rate.

Cost of Preferred Stock

At the moment, Home Depot does not have any preferred stock.

March 19, 2018 WACC calculations 2

The Cost of Common Equity
a. Based on CAPM model
Ke = Rf + ßi(Rm - Rf)

To calculate Beta, Adjusted close Prices of Home Depot and S&P 500 of each month from 1st
of January 2013 until 1st of March 2018. In order to get the Risk free rate, 5 years US bonds
were used. The ten year rate on US bonds was obtained for five years as well, and it was
compounded monthly. The reason why we used US bonds, is because Home Depot mostly
operates in North American continent. As it can be seen in the table below, our calculations
gives us a Beta of 1,128.

Coefficients
Standardized
Unstandardized Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) ,008 ,005 1,564 ,123
SP500 1,128 ,167 ,662 6,735 ,000
a. Dependent Variable: HD

In order to check the reliability of our beta, we have decided to compare our result with
the following finance websites:

Beta Yahoo. Finance 1,07

Ycharts 1,143
Beta Reuters.com 1,16

Compute Market Return

MARKET VALUE NOW 2751,49

MARKET VALUE THEN 131,21
Rm 8,82%

In order to calculate market return, the price of S&P 500 when HD was first listed was taken
into account. Furthermore, the latest price of S&P 500 was found.

2751,49
Rm= 36√( ) -1 = 8,82%
131,21

March 19, 2018 The Cost of Common Equity 3

 Step 4: Calculate the Cost of Common Equity

For risk free rate (Rf), the latest ten year US treasury Yield was used. For computing the Cost of common
Equity the formula below was used. As it can be seen at the table below, according to our calculations,
the Cost of common equity for Home Depot is 9,58 %.

Ke = Rf + ßi(Rm - Rf)

Step 4: Calculate the Cost of Common Equity

Market Level Today 2751,49
Market Level Then 131,21
Rm 8,82%
Rf 2,89%
Rm-Rf 5,93%
beta 1,128
Re 9,58%

Dividend Growth rate model

Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth Rate
In order to get next year dividend per share, Home Depo’s website was used to check their dividend per
share price history. Home Depo pays its dividends quarterly, and we multiplied the quarterly dividend by
in four in order to get the yearly dividend per share price. As it can be seen in the table below, next year
dividend per share of Home Depo will be $4,12. We will use the formula below to calculate cost of equity
based on dividend growth model. Furthermore, the last five years dividend per share prices were used to
get the dividend growth rate.

Ke = (4,12/178,31) + 23,74% = 26,05%

Next Year Dividend 4,12

Current Stock Price 178,31
2,31%
Dividend Growth Rate 23,74%
Cost of Equity 26,05%

March 19, 2018 The Cost of Common Equity 4

WACC Sensitivity Analysis

𝐸 𝐷
𝑊𝐴𝐶𝐶 = ∗ 𝑅𝑒 + ∗ 𝑅𝑑 ∗ (1 − 𝑇𝑐)
𝑉 𝑉

Ke = 9,58% and MV weights

WACCa = (9,58% * 0,89047) +( 2,22% * 0,10953) = 8,77%
b) with Ke = 26,05% and MV weights
WACCb = (26,05% * 0,89047) + (2,22% * 0,10953) = 23,44 %
c) with Ke = 9,58 % and BV weights
WACCc = (9,58% * 0.71) + (2,22% *0.29) = 7,44%
d) with Ke = 26,05% and BV weights
WACCd = (26,05% * 0.71) + (2,22% * 0.29) = 19,13%

The reason why differ so much from each other is because of the high value of Cost of Equity based on
dividend growth. The disadvantages of this model are that it assumes constant growth of dividends and
does not consider risk of investments. Therefore, we decided to choose the first result of 9,58% with Cost
of Equity calculated by CAPM and MV weights. We chose this Ke because it looks at risk compare to other
Ke which uses dividend growth and ignores risks involved in the investments.

March 19, 2018 WACC Sensitivity Analysis 5

Market Assessment
According to Forbes, Home Depot and Lowe’s are
the number one and two home improvement
retailers in the USA. Home Depot holds 24% of the
market share, while Lowe’s holds 17% of the market
share. Home Depot has 1,977 stores compare to
Lowe’s which has 1,805 stores (Forbes). According
to Financial Post, Home Depot dominance is also
shown outside US market. As it can be seen in the
pie chart, Home Depot holds 16,1% of the Canadian
home improvement industry, followed by Lowe’s
Canada which holds 14,8% of the market share
(Ali).Home Hardware and Canadian Tire Retail, hold
13% and 12,2 % of the market share, and the rest of Figure 1: Home Depot Market Share
the industry holds 43,8 % of the market share.

Discount Fountain published a report in 2016 about the company's performance. According to this report,
the company's stock price was underestimated at $ 125. According to the author of the report, the target
price for 2018 is 201 dollars. The author has used FCF growth of 20%. He has used this percentage arguing
that Home Depot's dividend payout, and
increased demand for housing in United
States of America, justifies this forecast
(Fountain).

On the other hand, Jussi Hiltunen argues

that Home Depot stock price is 25%
overvalued. He considers that their
competitive advantage could be around
$40. Furthermore, the author of the
report states that the fair value of Home
Depot stock price should be around 110
dollar range. Also, the author takes into Figure 2: Free Cash Flow to sales (Cit. Seeking Alpha)
account a higher WACC, because he believes that
Home Depot is a risky investment due to possible housing crises in the near future. According to the
author, a new investor should be cautious and wait for better entry point (Hiltunen).

Our valuation of Home Depot is more realistic; therefore the value is smaller than what Discount Fountain
projects. The forecast in our valuation is based on six percent sales growth. Following this method, gave
us lower free cash flows. Furthermore, we used a higher discount rate of 8,77 % compared to Discount
Fountain, who uses seven percent to discount free cash flows. Because, Discount Fountain uses 20%
growth rate, makes his projection more optimistic. Therefore, we use industry growth rate to make our
future projections more realistic.
Bibliography
Ali, Anwar. www.business.financialpost.com. 24 October 2016. 24 October 2016.

Forbes. www.forbes.com. 26 May 2016. 26 May 2016.

Fountain, Discount. www.seekingalpha.com. 8 March 2016. 8 March 2016.

Hiltunen, Jussi. www.seekingaplha.com. 28 August 2017. 28 August 2017.

March 19, 2018 Bibliography 1