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Valuation and Analysis of Home Depot Inc.

Gracie Quintana Jeff Miller

Christine Kyrish Steven Poon

December 6, 2004

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Table of Contents

Financial Data Snapshot 1

I. Overview of Valuation 1

II. Business Summary 4

Products and Services 4

Competitors 6

Industry Analysis 9

Competitive Strategy 15

III. Accounting Analysis 16

Accounting Policies 16

Degree of Accounting Flexibility 19

Accounting Strategy 20

Quality of Disclosure 23

Quantitative Analysis 23

Red Flags 24

IV. Ratio Analysis and Forecasts 26

Ratio Analysis Section 27

Financial Statement Forecasting Methodology 29

Conclusion 33

V. Valuation 34

Cost of Capital 35

Method of Comparables 36

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Discounted Dividends 37

Discounted Free Cash Flows 38

Discounted Residual Income 39

Long Run Average Residual Income 39

Abnormal Earnings Growth 40

Altman’s Z-score 41

Results 41

VI. Analyst Recommendation 42

VII. References 43

VIII. Appendix 44

Industry Graphs 44

Ratio Analysis 45

Competitor Annual Financials 47

Quarterly Financials and Forecasts 49

Annual Financials and Forecasts 52

Calculations used in Valuations 55

Method of Comparables Valuation 56

Discounted Free Cash Flow and Sensitivity Analysis Valuation 57

Discounted Dividends and Sensitivity Analysis Valuation 58

Residual Income and Sensitivity Analysis Valuation 59

Abnormal Earnings Growth and Sensitivity Analysis Valuation 60

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• Investment recommendation: Home Depot is slightly overvalued therefore we

recommend it as a hold. The stock is poised to perform at least as well as the

market.

• Home Depot is expected to penetrate foreign markets; this growth opportunity

will increase market share and the bottom line.

• Uncertainty in the economy affects Home Depot’s sales, as it operates in a

cyclical industry. This uncertainty will not have a detrimental impact on the long

term growth of Home Depot and its subsidiaries.

I. Overview of Valuation Company and Industry Overview

The Home Depot, Inc. is the world’s largest home improvement retailer and the

second largest retailer in the United States, earning $64.8 billion in revenues during the

2003 fiscal year. Operating under the cost leader strategy Home Depot derives its key

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success factors based on a tight-cost control system, stability of sourcing channels, and a

growth strategy based on core competencies. Home Depot’s growth strategy permits

further market penetration by enhancing a value chain of lower priced premium products

and the expansion of new store formats to support growing market trends. The successful

integration of distribution centers that lower transaction costs, an expansive product

selection through exclusive and proprietary agreements, and the initiation of a quality

assurance program positioned Home Depot to earn consistent above-average profits

within a highly fragmented retail (home improvement) industry.

Accounting Analysis

The accounting policies adopted by the Home Depot prove to be in line with it’s

business strategy. Overall, the Home Depot is very forthcoming with their accounting

practices and policies. The specifically identify three major areas of accounting policy in

regards to their specific industry to further their business strategy as it relates to

merchandise inventories, self insurance and revenue recognition. The firm is proactive in

divulging accounting policy regarding each of these areas. They specifically address the

firm’s actions in regards to required GAAP changes and liberally discuss their adoption

of certain GAAP in their financial reporting such as their policy regarding the upcoming

change in policy for the firm in their treatment of operational leases as opposed to capital

leases. The firm goes as far as to forecast how the change in policy will affect future

financial statements in 2004 the notes to their 2003 financial documents.

Ratio Analysis

Computation of the ratios relevant to the home improvement retail industry shows

no significant problems for Home Depot. Home Depot is operating on relatively wide

margins compared to its competitors. Costs have been managed well and debts are being

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paid more slowly; this does not pose a problem because the average payment time for the

industry is much slower than Home Depot. The sustainable growth rate is quite high

compared to Lowe’s which can be explained by Home Depot’s innovative business

strategy.

Forecasting

Sales growth over the past five years has grown fairly consistently. The growth

rate in sales is assumed to continue into the future, with a similar upward trend in future

earnings. Recently, Home Depot has taken on more short term debt, but this should not

impact their capital structure significantly. Total assets have been steadily increased over

the past five years and that trend is expected to continue. There is not a large spread

between the operating cash flow and earnings, which is a good sign for the quality of

accounting information. The growth trend in assets and income and cash flow can be

expected to increase because of expansion into other countries, mainly China and

Mexico.

Valuation

Different methods of valuation were used to assess the value of Home Depot. We

have the most faith in the abnormal earnings growth, residual income, and discounted

cash flow valuation methods. In the abnormal earnings and residual income model, the

stock was overvalued. In the discounted cash flow method the stock was slightly

undervalued. In the method of comparables valuations, the stock was most accurately

priced by the P/E method. If modest growth rates are assumed, along with a beta slightly

above the market’s beta, Home Depot’s stock is slightly overvalued.

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II. Business Summary

The Home Depot, Inc. is the world’s largest home improvement retailer and the

second largest retailer in the United States. Home Depot distinguishes itself as the leader

of the retail (home improvement) industry by focusing on sales, service, and execution.

By utilizing this operating strategy Home Depot reported a sales growth of 11.3% during

the 2003 fiscal year earning $64.8 billion in revenues, up from $58.2 billion in 2002.

The Home Depot, Inc. has set itself apart from industry competitors by

implementing a growth strategy of strengthening its core competencies by offering every

customer a unique experience through store modernization, carrying a variety of

distinctive merchandise, providing high quality service associates, and expert information

technology. Subsidiaries of Home Depot, Inc. provide specialized services to both the

individual homeowner as well as the professional customer.

Home Depot has a competitive advantage over other firms in the industry by

creating a dimension of tight cost control and providing premium value to customers

through merchandise selection and expert service. Home Depot is currently operating

1,778 stores in the United States, Canada, and Mexico. The Home Depot, Inc. is in a

highly competitive industry that is based on the factors of price, store location, customer

service, and depth of merchandise. Home Depot estimates that its share of the U.S. home

improvement industry is approximately 11 percent. Globally the home improvement

industry is approximately at $900 billion offering extraordinary growth opportunities.

The Company experienced an increase in comparable store sales of 3.8% in fiscal 2003

with an average ticket of $51.15, the highest in company history. The lawn and garden

category was the biggest driver in fiscal 2003 for the boost in store sales. This increase in

comparable lawn and garden sales can be tied to firm rivalry in the Southern United

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States, between Home Depot and Lowe’s, where a growing customer base and loyalty is

being won or lost as patrons have been affected by three hurricanes within thirty days of

each other.

Products and Services

Home Depot provides a blend of high-quality merchandise for all areas of home

improvement. In a highly competitive market Home Depot relies on competitive pricing

strategies, service-oriented associates, and supplying a combination of higher-end

premium products at a fair value. The Home Depot, Inc. provides specialized services to

the customer market through two main types of stores, Home Depot Stores and EXPO

Design Center Stores.

Home Depot Stores sell a wide range of building materials for home improvement,

lawn and garden products, and provide a number of valuable services. HD expanded a

number of in-store initiatives and programs to increase customer loyalty including:

• Professional Business Customer Initiative: The Company increased the available

quantities of products typically purchased by professionals in bulk to provide

additional savings to the customer. HD has successfully anchored a position as a

cost leader through this initiative of a tight cost control system and low-cost

distribution.

• Color Solutions Center: HD provides leading paint brands and proprietary paint

matching technology.

• Appliance Sales: HD provides customers with unique premium appliances

manufactured by General Electric, Maytag, and other leading manufactures as

well as displaying and stocking the more popular appliances in the store.

• Designplace Initiative: Offering an enhanced shopping experience to design

customers HD highlights its core competencies with superior product variety and

customer service. HD provides personalized service, specially-trained associates,

and an expansive merchandise selection.

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• Tool Rental Centers: HD rents approximately 225 commercial-quality tools in 12

categories, including saws, floor sanders, generators, gas powered lawn

equipment, and plumbing tools to satisfy a broad range of the needs of

professional and do it yourself customers. This initiative allows HD to operate

under a tight cost control system and emphasize a key success factor of high

quality merchandise.

EXPO Design Center Stores offer interior design products, such as kitchen and

bathroom cabinetry, soft and hard flooring, appliances, window treatments, lighting

fixtures, and arrange installation services through qualified independent contractors. The

EXPO Design Center Store focuses on distinguishing itself from other industry

competitors by providing a strong value chain network of premium products and

accentuating core competencies within the business segment.

Competitors

With few direct competitors found within the highly fragmented home

improvement industry, Home Depot has differentiated its stores by offering several

unique formats to accommodate the needs and interests of customers while offering

products at a cost lower than the premium price customers are willing to pay. Of the

1,788 stores The Home Depot, Inc. was operating at the end of the second-quarter of

fiscal 2004 1,569 are Home Depot stores, 54 are Expo Design Centers, 11 Home Depot

Landscape Supply SM, 5 Home Depot Supply SM, and 2 Home Depot Floor Stores. For

this reason The Home Depot, Inc. has pitted itself against competition outside of its

immediate industry, retail (home improvement), and increased the high threat of

substitute products.

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Lowe’s Companies, Inc. (LOW) is the second largest retailer of home

improvement products in the world with $33.9 billion in revenue for the 2003 fiscal year.

With low switching costs to customers Lowe’s is Home Depot’s main rival within the

industry. Lowe’s serves and specializes in the do-it-yourself (DIY) customers,

appliances, lawn and garden, home décor, repair/remodeling, specialty trade contractor,

and property management market segments of the home improvement industry. Lowe’s,

as of January 31, 2003, operated 854 stores in 44 states with approximately 94.7 million

square feet of retail selling space. The company is operating under an aggressive growth

strategy focusing much of its future expansion on metro-markets with populations of

500,000 or more.

Lowe’s home improvement warehouse carries over 40,000 products and each

store provides a wide selection of nationally advertised brand name merchandise. Of the

thousands of items offered, both in the store and available through its special orders

system, Lowe’s merchandise selection supplies both the do-it-yourself (DIY) customer

and the commercial business customer with products and merchandise needed to repair,

maintenance, and complete construction projects. Lowe’s sources its products through

7,000 vendors worldwide, with no single vendor accounting for more than 4% of the total

purchases. The company is not dependent on a single vendor and has alternative

competitive distribution access available from suppliers to further increase its

opportunities for product quality and gross margin. The company has a strategic alliance

with HGTV network that allows it to exclusively run commercials for a substantial

portion of the commercial airtime. This is only one of a half dozen media partnership

programs employed to build the image and equity of the Lowe’s brand.

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Sherwin-Williams Company (SHW) generated $5.4 billion in revenue for the

fiscal year ending December 31, 2003 by engaging in the manufacturing, distribution,

and sale of coatings and related products to professional, industrial, commercial and retail

customers primarily in North and South America. The company relies heavily on

trademarks and trade name recognition, which significantly supplement the sales. The

Paint Stores Segment manufactures original equipment manufacturer (OEM) product

finishes. Original equipment manufacturer product finishes are sold to certain shared or

dedicated paint stores and by direct outside sales representatives building strong and

exclusive relationships with both buyers and suppliers of paint. The company is a

leading manufacturer and retailer of paints, coatings and related products to professional,

industrial, commercial and retail customers. Sherwin-Williams has a competitive

advantage over EXPO Design Centers by sustaining their industry position as the leading

manufacturer and retailer of paints. The sustainability of competitive advantage is

volatile depending on both product offered and market.

Tractor Supply Company (TSCO) is focused on supplying products for the

lifestyle needs of the recreational farmers and ranchers as well as tradesmen and small

businesses. The Company has identified a specialized market niche and focuses its

product mix on these core customers. The Company utilizes an “everyday low price”

strategy and offers exclusive top quality private label products to sustain a strategic

advantage over general merchandise, home center, and other specialty stores. Tractor

Supply Co. created a uniform store layout to provide maximum sales and operating

efficiencies. The company believes that is has differentiated itself by from “big box”

retailers by focusing on the specific needs of a target customer base. By utilizing this

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strategy TSCO has strengthened its value chain in comparison to Home Depot’s lawn and

garden segment.

Building Materials Holding Corporation (BHMC) is one of the largest

residential construction service companies in the United States with sales in excess of $1

billion. The Company specializes in providing construction services, manufactured

building components, and high quality materials to residential builders and contractors.

By targeting professional builders and contractors BHMC has positioned itself to gain

high-volume repeat customers. Building Materials Holding Corp. operates by

concentrating on manufacturing and installation services, on-time job-site delivery, and

volume purchasing which are not typically offered at smaller consumer-oriented retailers

but will become important to sustain a competitive advantage as the “baby boomer”

generation moves into the do-it-for-me (DIFM) segment of the market.

Griffin Land & Nurseries Incorporated (GRIF) is operated by its wholly owned

subsidiary, Imperial Nurseries, Inc. The landscape nursery business is extremely

fragmented, and the Company believes that its sales volume places it among the 20

largest landscape nursery growers in the industry. Imperial is currently reviewing a

number of ways to increase return on assets for its growing operations such as an increase

in the percentage of its product sold to retail garden centers. Sales to garden centers

generally have more favorable gross margins than those from sales of mass

merchandisers. The Company’s growing operations have been effected by seasonality

and increased shipping costs through distribution channels.

Industry Analysis

The retail (home improvement) industry is highly fragmented and has few direct

competitors for The Home Depot Inc. The Home Depot, Inc. and Lowe’s Companies,

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Inc. dominate the industry, controlling more than 30% of the U.S. market; Lowe’s, to

date, remains Home Depot’s single direct competitor within the industry. Home Depot,

Inc. has several store formats to compete in this highly fragmented industry, the store

formats include the traditional Home Depot store, EXPO Design Center store, The Home

Depot Supply store, Home Depot Landscape Supply, and The Home Depot Floor Store.

The estimated market share holding for Home Depot in the home improvement industry

is 11% at end of fiscal year 2003 but because of the fragmented industry measuring the

effect of sales against competitors is extremely difficult. The “Five Forces Model”

associates the intensity of competition and determines the potential for creating abnormal

profits by the firms within the industry.

Rivalry Among Existing Firms

The retail (home improvement) industry has an extraordinary opportunity for

growth globally. Viewed as once a stagnant market Home Depot has estimated the

global home improvement industry to be approximately $900 billion with enormous

potential for abnormal profits. Home Depot, Inc. is capitalizing on this by operating 102

Home Depot stores in eight Canadian provinces and 18 Home Depot stores in Mexico.

To increase customer base and service levels Home Depot often opens new stores near

the edge of market areas currently served by existing stores. This operating strategy,

known as ‘cannibalization,’ initially has a negative impact on store sales but provides for

long-run profitability by increasing customer service levels, gaining incremental sales,

and enhancing long-term market penetration.

The retail (home improvement) industry is highly concentrated with few publicly

traded direct competitors. Home Depot defines itself through an operating strategy based

on core competencies, premium merchandise, and lower costs.

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Threat of New Entrants

The Home Depot, Inc. offers product category leadership by offering high-end

appliances through exclusive agreements with manufacturers, superior quality service by

providing free how-to clinics, kiosks enabling customers to identify projects and print

step-by-step instructions in the store, and remains a cost leader through tight cost control

by offering tool rental centers to customers which offer 225 commercial-quality tool in

12 categories.

Most of the premium merchandise offered in Home Depot is purchased directly

through the manufacturer. Home Depot has formed strategic alliances and exclusive

relationships with a number of suppliers to market products giving Home Depot an

absolute cost advantage over new entrants. Home depot is dependent upon the timely

execution and delivery of products to its stores to maintain an inventory of competitively

priced premium products. To compete nationally Home Depot has built central

distribution centers to process globally sourced merchandise more efficiently. Transit

facilities have effectively lowered the number of distribution centers required in the

United States and Canada. Home Depot utilizes 10 transit facilities in the United States.

It is here that Home Depot receives and processes merchandise from manufacturers and

then immediately cross-docks it onto trucks for delivery to specific stores.

Approximately 40% of the merchandise shipped to the stores was processed through the

network of distribution centers and transit facilities with the intent of lowering

distribution costs and increasing seamless efficiencies for the end-consumer.

Threat of Substitute Products

Customers’ willingness to switch is often the critical factor in making the

competitive dynamic work. Home Depot maintains a global merchandise program to

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source high-quality products directly from overseas manufacturers, which gives the

customers an expansive selection of innovative products and better value, while

enhancing gross margin. Outside, smaller, retailers have the ability to target a specific

need and interest of the consumer and to provide dedicated service and knowledge to an

individual customer. Strategic alliances from manufacturers for exclusive product

distribution in dedicated home improvement stores, such as Sherwin-Williams with

Dutch Boy paint, curtails the mass utilization of Home Depot’s paint mixing stations,

which represent an integral part of the store modernization. The Company offers a

variety of installation services expanding its market share based on the uniqueness of the

Home Depot’s core competencies and value chain.

Home Depot has recognized an opportunity for increased market share by

examining “mega trends” in the growth of the Hispanic population and the aging

population. Eighty-five percent of the nation’s homes were built prior to 1980 and will

be in need of frequent repair heightening the future opportunity of the “do it for me”

sector of Home Depot customers. Services provided by Home Depot include the

installation of carpeting, hard flooring, cabinets, water heaters, and solid surface

countertops through qualified independent contractors in the U.S. and Canada, lending

itself out as a unique service provider to the consumer.

Bargaining Power of Buyers

Home Depot buys store merchandise from vendors located throughout the world

and is not dependent on any single vendor establishing the Company’s bargaining power,

relative to that of the supplier’s, high. Merchandise is bought directly through the

manufacturer and shipped to stores through transit facilities. Home Depot employs a

global sourcing merchandising program into its core strategy to source high-quality

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products directly from overseas manufacturers. Product development associates travel

internationally to identify opportunities to purchase items directly for Company stores

eliminating the “middleman” costs allowing Home Depot to develop a price sensitive

product selection for the consumer and increase the Company’s gross margin. HD has

established strategic alliances with certain suppliers to market products under a number

of proprietary and exclusive brands. Home Depot has two sourcing offices located in

Shanghai and Shenzhen, China, and has a product development merchant located in

Bonn, Germany. These assignments allow HD to advance product features and quality,

to import products not currently being offered to customers and furthers the operating

strategy of offering premium products at a lower cost than would be available through a

third-party vendor.

Bargaining Power of Suppliers

Home Depot’s suppliers are numerous with no supplier playing a major

contributory role critical to the Company’s business. HD currently source products from

more than 500 factories in approximately 40 countries. The Home Depot, Inc. has

initiated a quality assurance program to measure factors such as product quality, timely

shipments, and fill rate of all vendor performance. The quality assurance program has

established a strict standard to which product performance must adhere. Product testing

prior to purchase ensures the compliance of product requirements with HD specific

policies. Home Depot systematically evaluates product quality and factory performance

by conducting inspections at the factory to assure continued compliance with HD’s

product requirements. The retail (home improvement) industry allows Home Depot to

maintain considerable power over vendors because of their large buying power and

relatively low switching costs.

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Competitive Strategy

The Home Depot, Inc. has positioned itself within the industry based on a strategy

of cost leadership. This operating strategy allows the Company to earn above-average

profitability by dictating prices from suppliers lowering input costs and minimizing

distribution transactions eliminating the “middleman.” HD has developed a tight-cost

control system through quality assurance program that monitors vendor compliance with

Home Depot requirements. Home Depot has positioned itself for future business by

generating distinctive store formats to accommodate a diversified customer base allowing

HD to compete in niche markets such as lawn and garden and the private contracting of

home installation. Home Depot’s core competencies are centered upon the timely

execution and delivery of products to its stores to consistently providing an inventory of

competitively priced premium products.

Achieving and Sustaining Competitive Advantage

Home Depot must find a viable way to introduce new business segments and

services into the company structure while maintaining the image of comparable high-

quality value merchandise and service. The sustainability of Home Depot’s competitive

advantage is based on the Company’s ability to control cost at the source while providing

superior product variety and customer service. Key success factors for The Home Depot,

Inc. are the stability of costs and availability of sourcing channels, lowering input costs

through monitoring of vendors, and concurrently escalating efficiency at all levels for the

end-consumer. Home Depot currently has both the resources and capabilities to maintain

these key success factors. Improved inventory management resulted in lower shrink

levels for imported products, and enhanced service associates contributed to an increase

in average ticket growth in every selling category, with an average of 8.2 percent, from

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$4.13, to $54.73, in the second quarter of fiscal 2003. Fluctuations in the U.S. economy,

the Company’s ability to retain highly qualified associates, unforeseeable and unusual

weather conditions, and the impact of competition remain deterrents to maintain a

profitable going-concern for The Home Depot, Inc. Home Depot’s value chain is

expanding to accommodate a balanced consortium of customers. The value chain

includes the introduction of paint centers, tool rental centers, trained associates, increases

in technology, and store modernization customizing formats to the needs of the market.

Applying The Cost Competitive Strategy

Home Depot has maintained a competitive strategy to date through the integration

of low transaction costs, premium quality merchandise, and specialized services to meet

the demand of growing niche markets. HD has developed a growth strategy anchored in

continuously assessing opportunities to increase customer loyalty, increase sales, and

further market penetration. The Home Depot, Inc. grew service revenues by

approximately 27 percent to $883 million in fiscal 2003. In fiscal year 2003, HD acquired

White Cap Construction Supply, Inc., to operate 74 Pro distribution branches across the

country. Home Depot’s strategy remains strengthening its core competencies through

quality assurance and consistent competitive prices. Expansion of tool rental centers to

925 stores in the United States, the purchase of 20 Home Mart stores in Mexico, and the

operation of 1,788 stores in the U.S. are attributed to Home Depot’s key success factors

and competitive cost strategy.

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III. Accounting Analysis

The Home Depot, Inc. Accounting Policies

The retail industry, in general, presents a very competitive market with high price

competition and low product differentiation. Although almost any retailer, from

supermarkets to superstores, can offer home improvement items at a competitive price,

the home improvement industry currently provides a great opportunity for differentiation

in regards to the types of services home improvement retailers offer. To successfully

maximize sales and increase revenues in the home improvement industry, retailers such

as Home Depot must successfully combine product variety, quality and price and

specialized services. As discussed earlier, Home Depot has adopted a business strategy

based on these key factors. Consequently, as we look at Home Depot’s overall financial

results, it is necessary to focus on key accounting policies adopted by the company to

measure critical factors and risks.

In the “Management’s Discussion and Analysis of Results of Operations and

Financial Condition” of The Home Depot, Inc 2003 Annual Report

(www.homedepot.com), management identified three major areas as areas of critical

accounting policy and discussed the adoption of four different accounting

pronouncements. In addition to the four recently adopted accounting pronouncements

identified in the management’s discussion, The Home Depot identified four other major

accounting policy changes in it’s “Notes to Consolidated Financial Statements”.

Specifically, The Home Depot adopted four different accounting pronouncements in

regards to service revenue recognition, vendor allowances, goodwill amortization and

stock based compensation. The three critical accounting policies, as identified by The

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Home Depot management refer to the treatment of merchandise inventories, self

insurance and revenue recognition.

Merchandise Inventory policy is specifically addressed by The Home Depot

management in “Management’s Discussion and Analysis of Results of Operations and

Financial Condition” and is assessed in two different ways. Approximately 93% of total

inventory is valued at the lower of cost or market utilizing FIFO under the retail

inventory method with the other 7% valued under the cost method. The Notes section of

the Financial Statements accounts for the two different methods. According to the Notes,

the 7% of inventory valued under the cost method was due to inventory policy of certain

subsidiaries and distribution centers. In addition, The Home Depot, Inc. takes a physical

inventory count on a regular basis at each store to verify that inventory amounts in the

merchandise inventory section of the Consolidated Financial Statements are accurate.

Lastly, in regards to merchandise inventory, the company does account for possible

inventory shrinkage or swell based on historical results and industry trends.

Self Insurance accounting policy for Home Depot addresses it’s treatment of

“losses related to general liability, product liability, workers’ compensation and medical

claims”. The total liability is estimated on the total cost incurred as of the specific

balance sheet date and is not discounted. The estimate is based on “historical data and

actuarial estimates”. The company also explains in it’s Management Discussion that they

ensure estimates of liability are as accurate as possible by having both management and

third-party actuaries review the estimates on a quarterly basis.

Revenue Recognition is the third critical accounting policy identified by The

Home Depot management. Revenue recognition at the Home Depot follows the industry

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norm of recognizing revenue when the customer takes possession of the merchandise or,

if a customer makes payment prior to take ownership of the merchandise, Home Depot

records the sale as Deferred Revenue on the balance sheet until the sale is finalized when

the customer takes possession of the paid merchandise. Additionally, because The Home

Depot also provides a variety of services through their installation and home maintenance

programs, they also recognize service revenue at the time when the service is completed

and also record any customer pre-paid service revenue as Deferred Revenue on the

balance sheet.

Lastly, Home Depot management discusses four accounting pronouncements

dictated in 2003 that could possibly affect their 2003 Consolidated Financial Statements.

The first pronouncement, Staff Accounting Bulletin No. 104 (SAB 104)1, issued in

December 2003, addresses the SEC’s view on the treatment of revenue recognition in

accordance to GAAP. According to Management’s Discussion, this pronouncement had

no affect on their consolidated financial statements. The second pronouncement,

Statement of Financial Accounting Standards No. 150 (SFAS 150), “Accounting for

Certain Financial Instruments with Characteristics of Both Liabilities and Equity”2,

issued in May 2003, did not have any impact on the Home Depot’s 2003 Consolidated

Financial Statements according to Management’s discussion. The primary reason for the

lack of impact is because of SAFS 150’s effective date. SAFS 150 applies only to

instruments “entered into or modified after May 31, 2003” or “at the beginning of the

first interim period beginning after June 15, 2003.” The third accounting pronouncement

was issued in April 2003. Statement of Financial Accounting Standards No. 149

(SFAS 149), “Amendment of Statement 133 on Derivative Instruments and Hedging

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Activities”3 again did not affect Home Depot’s 2003 Consolidated Financial Statements

because of it’s effective date. The amendment affect contracts entered into or modified

after June 30, 2003 and were integrated into the consolidated 2003 statements. The last

pronouncement, a revision the FASB’s Interpretation No. 464, requires Home Depot to

consolidate any variable interest entities “if a company’s variable interest absorbs a

majority of the entity’s losses or receives a majority of the entity’s expected residual

returns, or both”. The FASB requires any company falling into this situation to

consolidate the entity in the first reporting period that ended after March 15, 2004 and so

Home Depot committed to integrate the change in the first Quarter of 2004.

Home Depot does comment on almost all portions, assets (revenues), liabilities

(expenses) and owners’ equity, of their financial statements items relevant to accounting

policy for each line item. Most of their policy statements are detailed while other

portions are vague or generic in terms of applied numbers. However, The Home Depot

does disclose changes for most of their critical accounting policies in either the

Manager’s Discussion or in the Notes to Consolidated Financial Statements.

Degree of Accounting Flexibility

The Home Depot, Inc. has an average degree of flexibility, as do many in the

retail industry. For example, most retail companies have flexibility in selecting their

policy on inventory valuation. The Home Depot chose FIFO in comparison to LIFO, for

example, and combines both cost and retail methods in inventory valuation. A

comparison of Home Depot’s depreciation policy to those of similar retailers shows

consistency in the depreciation schedule of various fixed assets. Home Depot also has

an option on how to depreciate or amortize intangible assets, such as goodwill, and a

comparison to their largest competitor, Lowe’s Home Improvement, provides another

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example of differing accounting options and decisions. Oppositely, the company has

very little option in how they recognize revenue, either sales or service revenue, as

discussed under Management’s discussion; Home Depot was recognizing service revenue

at the time the service was completed prior to the issuance of SAB 104. Home Depot had

to, overall, address four different accounting pronouncements in 2003 limiting some of

their accounting flexibility.

Another aspect of The Home Depot’s accounting flexibility is evident within their

financial statement disclosures. A comparison of the Management’s Discussion of

Financial Results and Notes to Consolidated Financial Statements for The Home Depot

and Lowes Home Improvement yields much more data in The Home Depot’s documents.

Some general examples include The Home Depot’s disclosure of financial data in table

form comparing the last 2 years to the current 2003 statements and summarizing, within

the notes, the overall impact of the accounting policies, changes to specific accounts,

and/or changes to liabilities or estimates. In some cases, it specifically lists future

estimates and the impact of those estimates for the upcoming financial period (2004) as in

the notes regarding capitalization of interest expense on capitalized leases.

Accounting Strategy

Further analysis of key accounting policies and advantages and disadvantages can

help us better identify some of The Home Depot’s actual accounting strategy.

The use of FIFO vs. LIFO in inventory valuation can tell give us some information on

The Home Depot’s accounting strategy. We can only assume that FIFO is utilized by

The Home Depot because most inventories in the retail industry are a FIFO physical

flow. Secondly, although LIFO would lower taxable income, LIFO could be utilized to

manipulate net income (liquidation of older layers at historical costs could affect COGS

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and consequently, net income). In the retail industry, FIFO more closely matches Just In

Time Inventory because of high inventory turnover in the industry overall. From an

operational management standpoint, FIFO also provides higher profits at higher price

levels. We assume from sections of Management’s discussion and from an industry

tendency, that bulk purchases of inventory usually involve discounts from manufacturers.

FIFO then allows the Home Depot to sell at a higher price to the consumer translating

into higher profit margins for the firm. Management’s Discussion partially attributes a

higher gross profit, an increase of 13.7%, to “Improved inventory management, which

resulted in lower shrink levels, increase penetration of import product, which typically

have a lower cost”. Overall, inventory management can have a dramatic impact on both

balance sheet and income statement results.

Other items that must be analyzed to help identify actual accounting strategy are

accounting pronouncements mentioned in the Notes section of the 2003 Consolidated

Financial Statements. Perhaps the most impacting of these pronouncements was EITF

02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration

Received from a Vendor”. EITF 02-16 states that “cash consideration received from a

vendor is presumed to be a reduction of the prices of the vendor’s products or services

and should, therefore, be characterized as a reduction in Cost of Merchandise Sold”.

According to the Manager’s Discussion, The Home Depot received consideration in the

form of advertising allowances. Prior to the adoption of EITF 02-16, this had the affect

of increasing intangible assets (prepaid advertising) and decreasing advertising expense.

In both 2001 and 2002, advertising allowances provided by vendors exceeded gross

advertising expense by 31 million and 30 million respectively and were recorded as

25

reductions in COGS. Again, this reduced expenses and maximized net sales, increasing

net profit. However, The Home Depot does disclose, in their 2003 Consolidated

Financial Statements, the affect of the change at the end of the 2003 fiscal reporting

period and estimated changes in COGS (decrease), the increase in operating expense

and the reduction in inventories on a Pro Forma table within the Manager’s Discussion.

Another actual accounting strategy can be analyzed in the treatment of Cost in Excess of

Fair Value of Net Assets Acquired. According to the Notes, The Home Depot stopped

amortizing goodwill effective February 2002 (under SFAS 142, “Goodwill and Other

Intangible Assets”). Accordingly, Home Depot recorded impairment charges of $0 in

2003, perhaps inflating assets on the balance sheet and deflating expenses on the income

statement. Yet another example of accounting strategy is The Home Depot’s policy

regarding capital leases. The company discloses in its Notes that it exercised its option

to purchase certain assets in December 2003 that were previously leased in an off-balance

sheet agreement with a special purpose entity. However, not until late in the financial

period does the company acquire the asset with a related expense for fair market value

and related depreciation expenses. One last item that should be mentioned is the

inclusion of assets from both the Canadian and Mexican subsidiaries. In comparison to

U.S. federal taxes, foreign taxes liability accounted for only 5% and 3% in 2003 and 2002

respectively while federal tax liability account for 82 % and 83% in 2003 and 2002

respectively.

Based on the analysis of these accounting strategies and changes in strategy in

2003, our assertion of The Home Depot’s actual accounting strategy would be that The

26

Home Depot practiced an aggressive accounting strategy where assets were maximized

and expenses were minimized.

Quality of Disclosure

Qualitative Analysis of The Home Depot’s disclosure should be discussed. It is

our opinion that there is more than adequate discussion of business strategy and risks in

The Home Depot’s 2003 Consolidated Financial Statements. Specifically, in the

Chairman’s Letter, Bob Nardelli, Chairman, President and CEO, summarizes the overall

fiscal year 2003 results and financial condition and well as key initiatives. Additionally,

there is sufficient detail disclosed on policy and changes in policy during 2003. Not only

is policy disclosed, the company goes a step further and discloses projections to account

for those changes as exemplified in their disclosure of the effect of EITF 02-16, the

changes in capitalized lease policy as well as financial projections of this change into the

first quarter of 2004 and in discussions such as the reasoning for an increases in SG&A

expenses. One shortfall, however, does exist in the quality of segment reporting,

which is almost non-existent and could be broken out into geographical segmentation,

to account for U.S. results versus Canadian and Mexican subsidiary results or into

product segmentation, given the listing of initiatives such as tool rental, flooring, pro-

services, appliance sales and lawn and garden sales. Overall, we deem The Home

Depot to be forthcoming in their accounting policy and assess the quality as good to

excellent.

Quantitative Analysis of the Company’s accounting should also be addressed.

Because the Company is in the retail industry, and as asserted earlier, has to be measured

on items such as inventory, we will consider certain sales and expense diagnostics as

follows:

27

Potential “Red Flags”

The existence of a special purpose entity with regards to Capital Leasing options

for certain assets (distribution centers, warehouses, retail locations and office space) was

established for the purpose of leasing these assets “off the balance sheet”. As discussed

in the Notes to the 2003 Consolidated Financial Statements, the Company took their

option to purchase the assets and include the asset on the consolidated balance sheet for

fiscal year 2004. Once the option to buy the assets was made in December 2003, the

special entity was dissolved. All policy regarding this transaction as well as a discussion

28

of the impact of this decision are disclosed in the Notes to the 2003 Consolidated

Financial Statements.

Notes 1. Revises or rescinds portions of the interpretative guidance included in Topic 13 of the codification of staff accounting bulletins in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The principal revisions relate to the rescission of material no longer necessary because of private sector developments in U.S. generally accepted accounting principles. Also rescinds the Revenue Recognition in Financial Statements Frequently Asked Questions and Answers document issued in conjunction with Topic 13. Selected portions of that document have been incorporated into Topic 13. U.S. Securities and Exchange Commission [on-line]. Selected Staff Accounting Bulletins: SAB 104; available from http://www.sec.gov/interps/account.shtml; Internet; accessed 28 September 2004. 2. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements. Financial Accounting Standards Board [on-line]. FASB Pronouncements: Statements of Financial Accounting Standards; Statement 150; available from http://www.fasb.org/st/#fas150; Internet; accessed 28 September 2004. 3. This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. Financial Accounting Standards Board [on-line]. FASB Pronouncements: Statements of Financial Accounting Standards; Statement 150; available from http://www.fasb.org/st/#fas149; Internet; accessed 28 September 2004. 4. This Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, addresses consolidation by business enterprises of variable interest entities,* which have one or both of the following characteristics: The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity.

1. The equity investors lack one or more of the following essential characteristics of a controlling financial interest:

a. The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights

29

b. The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities

c. The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses.

Financial Accounting Standards Board [on-line]. FASB Pronouncements: Summary of Interpretation #46; available http://www.fasb.org/st/summary/finsum46.shtml; Internet; accessed 28 September 2004.

IV. Ratio Analysis and Forecasts

Introductory Section:

Purpose of this section: The fundamentals behind Home Depot look good and

have proven profitable, but it is necessary to evaluate the company based on its actual

numbers and analyze that against the competition. It is possible to use analytical methods

to take into account business factors and outside factors that will affect the firm and

predict the economic effects on the firms financial statements. Methods employed in this

analysis include, time series analysis, cross-sectional analysis, ratio analysis, prospective

analysis, analysis by charts.

A general idea of the opportunities facing the firm and how well the firm has

already exploited its opportunities can be gained by doing this analysis. It is beneficial to

current and potential investors to see the potential performance of an investment in this

particular company.

Financial Ratio Analysis Section:

In this section, five years of annual data filed with the SEC have been used to

perform a ratio analysis of Home Depot and evaluate the company’s liquidity,

profitability, and capital structure. Specific ratios that are chosen for this industry outside

of the basic 14 are there because they represent a pertinent success factor for the business.

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Ratio Analysis

Liquidity:

Home Depot appears to be a solid company after computing relevant

ratios. A few ratios indicated that there may be some change in capital structure and

operating efficiency. Overall, no significant problems exist.

Home Depot is not struggling to pay its debts to creditors. The quick ratio trends

upwards while, the ability to pay current debts has shown a downward trend. This trend

is not a cause for concern because some debt has been generated from expansion into the

Chinese and Mexican markets.

Because Home Depot collects payments (cash or other means of payment) at the

point of sale, the days’ receivables outstanding are low. Home Depot offers credit cards,

mainly to contractors and frequent shoppers; this is the main thing keeping the

receivables ratio from being even better. Another key ratio is the days’ supply of

inventory, being that Home Depot is a retailer. The days’ supply of inventory is fairly

stable (Days’ supply is currently 71.84) with a slight increase in last year’s data, not a

large enough increase to cause concern of obsolescence or impairment.

When compared to Lowe’s, Home Depot looks very similar in terms of liquidity.

Lowe’s collects is receivables a bit quicker and maintains a higher current ratio at 1.4, but

they hold quite a bit more inventory. Lowe’s is the main competitor of Home Depot and

it makes sense that their measures of liquidity would not stray too far from each other.

Profitability:

Both Home Depot, and Lowe’s are profitable companies that seem to have good

years together and decline together. The industry shows a trend to move upwards with

small increases in profitability. Home Depot operates on a gross margin above 30% and

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the net margin is nearly 7%. This margin is somewhat thin compared to other industries

but is wider than its competitors. The Home Depot is profitable because it generates

large amounts of sales and can take smaller profits on each sale.

One measure of profitability that did stand out concerned the operating expense

ratio. Lowe’s operating expense ratio has remained flat over the past five years and

Home Depot has gone up slightly. I do not believe this increase is significant or is a sign

of management problems. Selling, general and administrative expenses as a percent of

sales have increased slightly. The return on assets and return on equity ratio depicts that

Home Depot manages its assets better than Lowe’s and manages to generate a greater

return on assets and return for shareholders.

2004 ROE Breakdown

ROA = Net Income/Sales x Sales/Assets 4304/64816 x 64816/34437

0.664 x 1.8822 0.125

ROE = ROA x Assets/Equity

0.125 x 34437/22407 0.125 x 1.5369

0.1921 Capital Structure:

Compared to Lowe’s, Home Depot uses much less debt financing, whereas

Lowe’s uses over a third of debt financing. Both companies have the ability to make

good on their upcoming debts. In 2002 and 2003, Home Depot utilized more debt in

acquiring their basis in Mexico causing a surge in their debt to service ratio. Once

purchased, their service ratio decreased again to within an industry average in 2004.

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Other Ratios:

Home Depot is paying their debts slower; this can be seen in the day’s payables

and turnover ratios. This does not seem problematic because in past years Home Depot

paid much quicker than Lowe’s, now their ratios are the same. NOPAT and EBITDA

margins were included to show any differences between Lowe’s and Home Depot in

terms of non cash expenses since EBITDA does not include depreciation or amortization.

NOPAT shows the company in light of operating policy and excludes debt policy. Both

these ratios for both companies are very similar and show that they operate similarly.

Other Ratios were included to show how Home Depot chooses to manage its long

term assets relative to Lowe’s. They are both retailers, neither holds much cash on hand

to cover any debts that may arise immediately, both have similar policies for long term

assets in turnover and asset use.

The sustainable growth rate for home depot at the year end of 2003 is 0.22

whereas the growth rate for Lowe’s is 0.19. The sustainable growth rate for Lowe’s has

consistently been lower than that of Home Depot for all years analyzed here. Home

Depot has shown strong growth in past years but that growth will probably slow down

below what is sustainable.

Financial Statement Forecasting Methodology Section

Method for forecasting Quarterly income statement:

Sales have been about 23% for Q1, 27% for Q2, and I have forecasted that sales

will continue to be 25% of annual sales for Q3, with the other 25% coming from Q4. I

assume slower growth than is predicted by past trends. The growth seems well above the

industry average and I still make the assumption that sales will grow at 11% indefinitely.

The sustainable growth rate suggests that the company can grow at nearly 20%. An

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average company’s sales would be around 9% and Home Depot is an above average

company.

Cost of Goods Sold shows a slight decreasing trend in recent quarters. I would

expect to see a further decrease in costs to 67% of sales for the year. Costs are expected

to show a further decline in the future 10 years and I believe they will become stable at

65% of sales growing at a rate of 10%. Total Assets/Sales waver near the 2.0 mark, so I

make the assumption that total quarterly assets will be twice sales. A sporadic decline in

the growth of long term tangible assets can be observed; a level of 60% of total assets

will be assumed for tangibles at the beginning and end of the fiscal year; continuing to

fall to 55% in other months. There is a closer relationship and superior trend between

inventory/total assets than inventory/sales, therefore inventory will be maintained at 25%

of total assets and 1% higher for the beginning of the fiscal year as long as it continues to

reflect the current level of sales.

A trend has been established where more cash and marketable securities are held

late in the year and fewer in the beginning. A level of 13% of sales at the end of the year

and 9% of sales at the beginning are assumed, both numbers based on past data that will

continue. Long term intangibles show no sign of changing and are expected to remain

the same percentage of assets they are presently, 3.5%.

Method for forecasting quarterly Balance sheet:

The ratio of debt to equity has been stable for the past five years (approximately

0.06) I have no reason to believe this ratio will change. Home Depot has taken on more

short term debt than previous quarters but I do not believe this to have the ability to

significantly change the structure of Home Depot’s financing.

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There is no specific quarterly trend in common shareholders equity except that it

shows slight infrequent decreases, equity will be assumed to remain at 58% of total

liabilities and shareholders equity for the remainder of the fiscal year. Short Term Debt

will remain unchanged for the next two quarters, as it has for the past year.

A trend that has been interesting is that Home Depot is making good on its

payables more slowly (days’ payables increasing). I don’t expect to see a significant

increase in payables over the next two quarters because Home Depot does not appear to

have a cash shortage, so the payables balance is left at 19% of total liabilities and equity.

Other current liabilities show a trend of remaining relatively flat over past years. Other

long term liabilities show a stronger upward trend than long term liabilities so a 7%

growth rate based on growth in past data will be assumed.

Method for forecasting annual Income Statement:

From the quarterly income statements it can be assumed an 11% growth in sales

and 10% growth rate for cost of goods sold will continue into the future. It is my

assumption that growth in cost of goods sold will decrease around 2009 to remain at

about 65% of sales. Selling, general and administrative expenses as percent of sales

tends to fluctuate around 20% of sales in quarterly, and annual data, I forecast it to

remain at 21% of sales. Other operating expenses are assumed to remain constant and

continue to be 90 million for forecasting purposes.

As stated in the notes to the financial statements, the effective tax rate is 37%.

This was used to calculate future tax expenses.

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Method for forecasting annual Balance Sheet:

From my quarterly forecast I can say that assets for 2005 will be 39930, then for

subsequent years I will assume them to be 53% of sales. Because the fiscal year ends in

the middle of January and I forecasted the quarterly statements to end then I will transfer

the balance sheet values to year 2005 in the annual forecast.

Accounts Receivable tends to remain at about 3.5% of total assets in past data, see

no reason to forecast a change. For the annual forecast, I will assume that inventory is

14% of sales instead of using the common size data simply because the sales data seems

to more closely approximate the appropriate amount of inventory. Cash and Marketable

Securities are held at a 4% of sales. I calculated other current assets by working

backwards into them from an assumption that current assets make up a bit more than a

third (38%) of total assets. Long term tangible assets are 58% of total assets and

intangibles are 2.5% and are expected to be the same percentage in the future. I worked

backwards into other long term assets after calculating other values, since total assets

have already been calculated.

Short term debt shows a large increase this quarter. In management’s discussion

of results, management cites growth plan in areas such as the Floor store section of their

business and improvements in their existing stores in an effort to modernize some older

buildings. Our assumptions are that Home Depot assumed a larger short term debt to

finance these improvements. We expect this level of debt to normalize over the next year

as these improvements are short term investments in capital assets. Accounts payable

show faster growth relative to sales growth, this trend is expected increase to 13% by

0.5% per year and remain at this level. Total Current Liabilities show no specific trend as

a percent of total liabilities and equity or as a percent of sales (except that it is

36

increasing). Current Liability growth does seem to track growth in total current assets.

Current liabilities have grown faster than current assets, bringing the current ratio down

in the past where it is currently at 1.4. I will continue the trend into 2005 it is not my

belief that home depot will maintain the ratio here. It makes more sense to bring the ratio

closer to 1.5, where it will be in the long run. Long term debt is becoming a smaller and

smaller percentage of total sales and total liabilities and equity. I would not expect the

decreasing trend to continue any longer past 2005. Equity shows a consistent trend of

being 32% of sales and it is forecasted to continue.

Method for forecasting annual Cash Flows:

Home Depot hasn’t strayed too far in terms of performance on a cash basis

against performance on an accrual basis. This is a good sign for the quality of

accounting. We also assume that all balance sheet ratios will increase proportionately

with the sales growth rate. There aren’t any significant faults to be observed in the cash

flow of Home Depot, and future prospects for the firm look good as well. I calculated the

forecasted cash flow information by starting with a comparison of cash to sales. I then

took the data as a percent of sales for forecasting purposes.

Conclusion:

Home Depot appears to be a solid company that has recorded good performance

in past years. A prospective analysis of the company shows that future growth prospects

look good. Ratio analysis against the main competitor, Lowe’s, shows that Home Depot

is performing above the competition. Investors have rewarded Home Depot with better

stock price performance than that of the industry and the competition. Expansion into

other countries will fuel growth and make future financial estimates more appealing. I

would expect Home Depot to perform well in the future.

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Note: The industry graph, located in the appendix, shows the performance of the

specialty retailer (home improvement retail) industry as compared to Home Depot,

Lowe’s, and the S&P 500. Home Depot has outperformed the industry, the S&P, and its

main competitor, Lowe’s over 3 months.

The Lower chart shows the year to date performance of Home Depot; it shows that Home

Depot, Lowe’s, and the S&P all track the industry to some extent and that Home Depot

consistently outperforms the industry and its competitor.

V. Valuation

Introduction

After forecasting the financial statements for Home Depot, for ten years into the

future, it is essential to put these values into models in order to determine the value of the

equity. These values are based on assumptions of the future performance of the

company. This section will focus on discounted values at the cost of capital to the

company.

It is important that these valuations be done for several reasons. The market

consensus of the value of the firm should be compared to our calculation of intrinsic

value to determine if the stock is an attractively priced security. Depending on the level

of confidence we have in our forecasts and assumptions about the future prospects of the

firm, we will determine how accurate the valuation model is. Some models carry more

weight than others, but it is necessary to have valuations across a broad range of

variables. These valuations can also assist in assessing where the market thinks most of

the value of the firm lies, either in assets that are already in place, or in the firm’s future.

38

The specific valuations/models to be discussed in this section are:

• Method of Comparables

• Discounted Dividends

• Discounted Free Cash Flows

• Discounted Residual Income

• Abnormal Earnings Growth

• Altman’s Z-score

A sensitivity analysis has been performed where the cost of capital and the growth

rate implied by the market are determined. These implied values can be found on the top

of each valuation spreadsheet.

Cost of Capital

The cost of equity capital used for valuation purposes was calculated to be

11.79% using an equity risk premium of 5.3%. This premium was found from the

difference between a long run average of monthly returns on the S&P 500, and a long run

average of the returns on 20 year treasury bonds. The long term Treasury bond was used

to reduce the effect of short term factors that influence short term rates on t-bills. I

computed the cost of equity using both t-bills and t-bonds and I believe that the rate on

the 20 year treasury yields a closer approximation of the risk premium.

The cost of debt was calculated by using the average rate on long term debt

which was found in the notes to the financial statements. Home Depot’s debt structure is

68% long term debt with an average rate of 4.64%, and 32% short term debt with an

average rate of 1.79% (rate on commercial paper). The tax rate used to calculate the after

tax rate on debt is 37%.

39

Beta was calculated to be 0.99 which is lower than the published Value Line beta

of 1.3. Because of the significant difference between these two numbers, which can be

attributed to short term market factors affecting the firm return, I feel that the Value Line

beta is a better number to use for the purpose of valuation. Home Depot seems to hold

more risk than the average market risk because of the cyclical nature of the home

improvement retail industry.

WACC = (Kd (1-T)) (Vd/Vf) + Ke (Ve/Vf)

WACC = (0.0464(1-0.37) (15881/38331) + 0.1179(22450/38331)

WACC = 8.12%

The Weighted Average Cost of Capital was found using the values stated above

with the knowledge that approximately 41.5% of the firm is financed with debt and

58.5% is financed with equity. The WACC is 8.12%.

Method of Comparables Valuation

The method of comparables valuation was performed using current share prices

and shares outstanding. This method requires that several close competitors of Home

Depot be used to compute ratios and then be averaged. Home Depot most closely

competes with Lowe’s, but more than one competitor is required for the method of

comparables valuation. Five companies were chosen based on market share, and

products sold, and sector of the industry served. Most companies serve home consumers

and contractors, but some focus more on commercial customers.

The Building Materials Home Corporation mainly is a construction services

provider. The Fastenal Company is a wholesale distributor of construction supplies.

This company may not directly compete with home depot, but the companies share

several similar products and for valuation purposes, are comparable. Sherwin Williams

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Company is involved mainly in the selling of paint and paint supplies. This is more of a

specialty store, but is considered a competitor with Home Depot’s Expo centers, and

Home Depot because of similar product sales. Tractor Supply’s customers are ranchers

and tradesmen. It sells a wide range of products and can be considered a home

improvement retailer even though it targets mainly agricultural customers. Tractor

Supply most closely competes with Home Depot in sales of hardware. Lowe’s is the

most clear and accurate comparison to Home Depot. They directly compete with each

other and stock nearly all of the same products.

The comparables valuation is not considered to be one of the most accurate

measures, as can be seen by the range of values. This range could be caused by a lack of

close competitors due to a concentrated retail home improvement industry. The price

earnings ratio most accurately estimates the actual price of Home Depot’s shares. The

price to sales ratio was the furthest off, possibly because of the different sizes of the

companies used in the valuation. Revenues vary between the retailers because of

company size and market share. According to this valuation model, Home Depot is

overvalued.

Intrinsic Valuation Methods

Discounted Dividends

The Discounted Dividends method of valuation holds more weight in this

valuation process than does the method of comparables, mainly because of the lack of

direct competitors in the industry. Variation in price is not explained well by the

variation in dividends over time. The historical dividend growth rate shows some

consistency, so this rate was used in forecasting of dividends. Steady dividend growth is

expected to be seen in the future.

41

The cost of equity capital was used to discount the future dividends back to 2004.

The total present value of the forecasted 10 years of dividends amounted to 2.75 while

the terminal value, which was calculated assuming no growth on the dividend paid in

year 2014, amounted to 6.60. The stock is extremely overvalued according to this model.

I do not feel that the estimates of the forecasted values of net income are too

conservative. Moderate growth was forecasted and this would cause future dividends to

be smaller.

A sensitivity analysis of the Dividend Discount model shows that a 2.05% cost of

equity capital, or a 9.8% growth factor in the terminal value, would equate the value of

the equity with the market price. The implied cost of equity is not reasonable, but growth

is very reasonable and probable.

Discounted Free Cash Flows

Contrary to the discounted dividend model, the free cash flow model showed the

market price to be smaller than the intrinsic value of the stock. This model has more

explanatory power than the previous two models and carries more weight in the overall

valuation of Home Depot. The terminal value of the free cash flows is calculated using

the expected 2014 free cash flow. The free cash flows have been showing a decreasing

trend according to the forecast, but I do not expect this trend to persist into the future.

The estimated share price according to this model is 51.10. After a sensitivity

analysis of growth in the terminal value and sensitivity of the weighted average cost of

capital it can be determined that the market assumes a 9.69% weighted average cost of

capital. Because the intrinsic value is higher than the current market price, we would

have to assume either a higher weighted average cost of capital, or negative growth to

equate the market price with the intrinsic value.

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Discounted Residual Income

The discounted residual income valuation model has the most explanatory power

of all the models discussed so far. It links uses dividends to link book values to market

values. For this model, we will assume normal earnings to be calculated by: last years

earnings multiplied by 1+Ke. Because this model values the spread between expected

earnings and normal earnings, it cannot grow in an unbounded manner like discounted

free cash flows. Hence, we are valuing the residual income on a per share basis.

For this model, the implied cost of equity capital that will equate the current stock

price with the intrinsic value is 8.62%. The growth rate to equate the market value to the

intrinsic value is 8.9%. I feel that the implied cost of equity is slightly low for this stock,

but the growth in the terminal value is not unreasonable here. There is an increasing

trend in residual income which implies growth in the terminal value.

According to this model, the market price is overvalued by quite a bit. The value

is estimated to be 24.74. The calculation of the relative values will show where the value

lies in Home Depot. Assets already in place make up 40% of the value, the present value

of residual income makes up 37% of the value, and the future potential of the firm

measure by the terminal value makes up the other 23% of the firms estimated intrinsic

value. This explains that Home Depot is somewhat of a mature firm with a large

percentage of assets in place which lowers the risk of investors. The firm has 23% of its

value coming from future potential which can be seen as a sign of positive future

performance.

Long Run Average Residual Income Perpetuity

This residual income valuation is calculated by taking the difference between the

expected long run return on equity and the cost of equity. This difference is then used to

43

find a perpetuity while accounting for growth in the book value of equity. The return on

equity for Home Depot has been quite stable over the past five years, and I do not

forecast any significant changes in structure. The long run return on equity is 19%. The

historic growth in book value of equity has not been a constant value. There has been

significant fluctuations in this value, and the valuation will be done once assuming no

growth, and once with the implied growth rate. For forecasting purposes, the growth rate

is determined to be 11%.

P/B = 1 + (ROE - Ke) / (Ke - gbve)

P/10.23 = 1+ ((0.19-.1179) / (.1179-0))

P = 16.49 (assuming no growth in book value)

The Implied growth in book value of equity for this valuation is 9.49% which I

believe to be an attainable value. This model implies that the cost of equity is very low,

4.6%. In this model the stock is overvalued. The discounted residual income model is a

better valuation method for Home Depot and seems to better represent the market

consensus price.

Abnormal Earnings Growth Valuation

The objective of this valuation model is to value a stock with the assumption that

dividends are irrelevant. To do this it is necessary to assume that the dividend will be

reinvested at the cost of equity capital. The difference between the cumulative dividend

earnings and the normal earnings are the abnormal earnings. The total discounted

abnormal earnings growth added to the earnings per share and the present value of the

terminal value will be the estimated price.

44

Our abnormal earnings seemed to have a significant amount of variation. To

reduce the variation I chose to take the average of the forecasted abnormal earnings to

find the terminal value. If I had used the final year’s abnormal earnings, the stock would

have been extremely overvalued, which, based on the fundamentals of the business, I do

not believe to be the case. A cost of equity capital that is implied by the market was

found to be 9.45%. The implied growth rate is 10.20%. The terminal value was

calculated assuming no growth in abnormal earnings.

Altman’s Z-Score

Z-Score based on year-end 2003 Annual report with the Market Value of Equity

based on the current market price of $42.29 which was the same price used in our

valuations. Home Depot’s Z-Score fell higher than the 2.7 score required for credit

worthiness and falls in line with the estimated cost of debt.

Results and Conclusion

These valuation models offer a nice breakdown of the business and give

explanations of where the value of Home Depot is derived from. In the residual income

model, it was determined that most of Home Depot’s value comes from assets that are

already in place. Based on the valuation models used, Home Depot is overvalued in all

models except for the discounted free cash flows model. The method of comparables

valuation for the price earnings ratio was only slightly overvalued.

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Specific reasons for the difference between the value determined by a market

consensus and by these models are as follows: The estimation of the cost of equity and

the equity risk premium has a significant effect on the estimated value of the stock. For a

company with most of its value in assets already in place, the estimated cost of debt may

have been slightly high. If this were true, then the stock would be only fully valued.

Another factor that would have a substantial impact on the valuation is the forecasts the

valuations are based on. After comparison of these forecasts against published forecasts,

it is evident that the forecasts used in this valuation are more conservative in terms of

sales growth and earnings growth. This would have a similar effect that overestimating

the cost of capital would have. I am confident that using the published beta of 1.3 instead

of the beta determined in the regression analysis has yielded more accurate results.

Because the forecasts used in this valuation are on the conservative side, I would say that

Home Depot is slightly overvalued and while it is not being traded currently at an

attractive price, the company’s future looks positive.

VI. Analyst Recommendation

Home Depot is a financially sound company and performs well when compared to

its competitors. Based on current business conditions and the potential growth

opportunity facing Home Depot, we feel that the bottom line will continue to grow at a

healthy rate above the competition in the near future. We believe that the relatively low

levels of debt, slightly wider margins, and lower costs make Home Depot an attractive

investment for the long run. Shares of Home Depot are currently trading at a premium to

what we believe is the intrinsic value. This premium is possibly derived from the

market’s belief that better than predicted growth will be seen from expansion into foreign

markets, specifically China.

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Home Depot is a well managed business that has had a historically above average

performance. Because the shares currently appear to be slightly overvalued, we

recommend Home Depot as a hold. Risks to this recommendation include the threat of a

possible terrorist attack, and because Home depot operates in a cyclical industry,

fluctuations in economic conditions as well. Overall, Home Depot is a strong company

that is poised to outperform its industry and the market.

VII. References

1. Home Depot Annual Reports/Statements 2. Home Depot company website 3. Zacks.com 4. Yahoo finance 5. MSN Money 6. Edgarscan 7. Value Line 8. BigCharts.com

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VIII. Appendix

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Trend (Time Series) Analysis Home Depot Ratio Analysis 2000 2001 2002 2003 2004Liquidity Current ratio 1.75 1.77 1.59 1.48 1.40 quick asset ratio 0.21 0.23 0.53 0.41 0.41 accounts receivable turnover 72.79 64.33 61.03 58.48 59.77 days outstanding receivables 5.01 5.67 5.98 6.24 6.11 inventory turnover 5.53 5.32 5.63 5.33 5.08 days supply of inventory 66.06 68.57 64.80 68.49 71.84 working capital turnover 14.06 13.48 13.87 15.00 17.17Profitability gross profit margin 0.30 0.30 0.30 0.31 0.32 operating expense ratio 0.19 0.20 0.21 0.21 0.21 net profit margin 0.06 0.06 0.06 0.06 0.07 asset turnover 2.25 2.14 2.03 1.94 1.88 return on assets 0.14 0.12 0.12 0.12 0.12 return on equity 0.19 0.17 0.17 0.19 0.19Capital Structure debt to equity ratio 0.06 0.10 0.07 0.07 0.06 times interest earned -92.88 -199.57 -176.14 -157.57 -110.42 debt service margin 84.62 698.00 1189.80 687.14 12.90Other operating return on assets 0.16 0.14 0.15 0.16 0.16 NOPAT margin 0.06 0.06 0.06 0.06 0.07 EBITDA margin 0.10 0.09 0.09 0.10 0.11

operating working capital to sales ratio 0.11 0.12 0.08 0.09 0.09

operating working capital turnover 9.03 8.13 12.22 11.40 11.13 accounts payable turnover 13.56 16.22 10.89 8.80 8.57 days' payables 26.92 22.50 33.53 41.47 42.57 net long term asset turnover 3.68 3.42 3.42 3.31 3.17 PP&E turnover 3.76 3.50 3.48 3.39 3.23 cash ratio 0.05 0.04 0.39 0.28 0.30 operating cash flow ratio 0.67 0.64 0.92 0.60 0.69 liabilities to equity ratio 0.38 0.43 0.46 0.52 0.54 net debt to equity ratio 0.05 0.09 -0.07 -0.05 -0.09 debt to capital ratio 0.06 0.09 0.06 0.06 0.06 dividend payout ratio -0.11 -0.14 -0.13 -0.13 -0.14 sustainable growth rate 0.21 0.20 0.19 0.21 0.22

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Cross Sectional (Benchmark) Analysis Lowes 1999 2000 2001 2002 2003Liquidity Current ratio 1.55 1.43 1.63 1.56 1.53 quick asset ratio 0.30 0.21 0.34 0.36 0.40 accounts receivable turnover 107.54 116.65 133.55 154.02 235.40 days outstanding receivables 3.39 3.13 2.73 2.37 1.55 inventory turnover 4.10 4.11 4.36 4.65 4.63 days supply of inventory 89.07 88.91 83.71 78.44 78.81 working capital turnover 12.02 15.07 11.62 13.31 13.30Profitability gross profit margin 0.28 0.28 0.29 0.30 0.31 operating expense ratio 0.20 0.20 0.20 0.21 0.20 net profit margin 0.04 0.04 0.05 0.06 0.06 asset turnover 1.76 1.65 1.61 1.64 1.62 return on assets 0.07 0.07 0.07 0.09 0.10 return on equity 0.14 0.15 0.15 0.18 0.18Capital Structure debt to equity ratio 0.40 0.54 0.58 0.46 0.36 times interest earned 13.53 11.61 10.36 13.96 17.66 debt service margin 19.55 26.68 27.22 92.97 40.95Other operating return on assets 0.12 0.11 0.11 0.14 0.15 NOPAT margin 0.05 0.05 0.05 0.06 0.06 EBITDA margin 0.07 0.07 0.08 0.10 0.10 operating woking capital to sales ratio 0.06 0.06 0.05 0.04 0.03 operating working capital turnover 17.53 17.55 18.28 28.09 39.95 accounts payable turnover 7.36 7.79 9.18 9.50 8.97 days' payables 49.63 46.87 39.76 38.41 40.68 net long term asset turnover 3.00 2.61 2.51 2.52 2.50 PP&E turnover 3.07 2.67 2.56 2.56 2.58 cash ratio 0.24 0.16 0.28 0.31 0.37 operating cash flow ratio 0.49 0.39 0.53 0.75 0.72 liabilities to equity ratio 0.92 1.07 1.06 0.94 0.85 net debt to equity ratio 0.28 0.46 0.46 0.32 0.21 debt to capital ratio 0.29 0.35 0.37 0.31 0.27 dividend payout ratio -0.07 -0.07 -0.06 -0.04 -0.05 sustainable growth rate 0.15 0.16 0.16 0.19 0.19

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