case home depot

PREFACEAfter the successful completion of the course named “Investment Analysis” (F-307) of the BBA

program, preparation for the term paper provides us an opportunity to reduce the gap between the

theoretical knowledge & practical experience. To enhance the analytical competence, we were

given the onus to prepare a case study on Home Depot which has undoubtedly put fresh impetus

to our understanding of the Stock markets, interest rates and the growth rate of the company.

We tried to demonstrate the objective of the case analysis which is to illustrate the stock price

valuation breakdowns and the fall of the stock price. Moreover, we attempted to portray an

unbiased analysis and information about the company.

ACKNOWLEDGEMENT

First, our heartfelt gratitude should go to the Beneficent, the Merciful & Almighty Allah for giving us the strength and patience to prepare this report within the scheduled time.

We are deeply indebted to our course teacher, Dr. M. Sadiqul Islam, Professor, Department of Finance, University of Dhaka, for his kind cooperation and valuable contribution in preparing the report.

We also like to convey our thanks to those who helped us by providing necessary information regarding the Analysis.

At last, all the members of Group-04 should be acknowledged for their nice & dedicated service behind the making of the report.

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EXECUTIVE SUMMARYThe purpose of this project paper is to analyze the Home Depot, which was the first to really

commercialize the big-box format back in 1978. Home Depot has grown since then to become

the largest home improvement retailer in the world. The Home Depot is considered one of the

largest retail employers today. With the intensely competitive nature of the home improvement

retail segment, it becomes vital to not only make the exact product available to the customers at

the right price, but having sensitivity to serving what the customer needs will make the

difference in who gains competitive advantages. Although Home Depot has delivered superb

financial results since its inception, over the last six years they have encountered their share of

challenges to include eroding market share to Lowes, and severe organizational discontent from

shareholders, employees as well as customers with a deteriorating housing market. From the in

depth analysis of Home Depot and its primary competitors, it seems that Home Depot is

positioned well to move into the next millennium. Financially, Home Depot is very sound which

is good considering they will need vast amounts of capital to continue growth. Home Depot also

appears to be realizing investments from IT as well as operational efficiencies provided to them.

They should also be careful not to grow out of control due to imminent market saturation and

overall industry slowdown.

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CHAPTER 01BACKGROUND OF THE STUDY

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BACKGROUND OF THE STUDYThe Home Depot was formed in 1978 by Bernie Marcus and Arthur Blank in Atlanta, Georgia.

Home Depot virtually revolutionized the do-it-yourself home improvement industry in the

United States almost overnight. The two entrepreneurs opened their stores which were no frills

warehouses. Home Depot has grown so quickly, it has been able to garner significant

concessions in prices from suppliers. Home Depot was considered one of the largest retail

employers that time. With the intensely competitive nature of the home improvement retail

segment, it became vital to not only make the exact product available to the customers at the

right price, but having sensitivity to serving what the customer needs will make the difference in

who gains competitive advantages. Home Depot had also been able to establish and successfully

execute a market saturation strategy coupled with low prices and high service.

It had been reported that prior to the first store opening, Bernard Marcus was “so intent on

creating a warehouse feel that he raced around on a forklift, throwing on the brakes to create skid

marks on the floors”. The co-founders envisioned a huge warehouse store where all products

would be acquired and delivered almost instantaneously from the manufacturer’s production

floor. The hook for the customer was the promise of amazingly low prices, in an environment

where the do-it-yourself customer would be assisted by knowledgeable sales people, who

through their expertise, would instruct motivate and encourage customers towards what was

needed to fix and improve the home environment.

ORIGIN OF THE REPORT

The BBA program under the department of finance offers a course named “INVESTMENT

ANALYSIS” (F-307) which requires every group to submit a report on a specific topic

determined by the course instructor. The report under the headline “Case Analysis on home

Depot, Inc” has been prepared towards this purpose.

Objectives of the Study

The primary objective of this study is the partial fulfillment of the course requirement. The

objectives of this report are as follows:

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To familiarize with practical functions of Stock valuation of Home Depot.

To have an exposure on analysis of Stock and its fall of price.

To relate the rules and regulations with the practical functions of that company.

To present an overview of the financial performance of the company.

To appraise the Performance of it in the stock market over time.

Scope of the Study

Our honorable teacher assigned us the case and work on it. As per requirement we worked on

that case to make a report on Home Depot, Inc. In this report, we work on the data regarding the

financial performance of Home Depot, Inc. Here we create a overview on this sector. We only

clarify the subject matters which is relevant to our report topics assigned by our Course

instructor.

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CHAPTER 02INTRODUCING HOME DEPOT INC.

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INTRODUCING HOME DEPOT INC.

HOME DEPOT INC. An American retailer of home improvement and construction products and services.

Headquartered in Vinings, just outside Atlanta in unincorporated Cobb County, Georgia,

Established in 1978 by Bernie Marcus and Arthur Blank, the Home Depot Corporation

opened its first store in Atlanta, becoming the world’s largest home improvement retailer.

They are now the second largest retailer in the United States, offering different types of

home improvement supplies and building materials products.

They carry a wide assortment of low-cost products, and offer expert advice and

exceptional customer service.

As an innovator of the home improvement industry, Home Depot has expanded into

Canada, Mexico, Argentina, Chile, and Puerto Rico.

Home Depot caters to Do-It-Yourself customers, as well as home improvement,

construction and building maintenance professionals.

Home Depot’s stock went public in 1981 and is traded in the New York Stock Exchange.

IN 1988 Fortune magazine viewed Home Depot as “the only company that has

successfully brought off the union of low prices and high service”

At the end of 1999 it operated 930 stores, almost all of them in the US and Canada.

HISTORY OF HOME DEPOT

The Home Depot was formed in 1978 by Bernie Marcus and Arthur Blank in Atlanta,

Georgia.

Home Depot virtually revolutionized the do-it-yourself home improvement industry in the

United States almost overnight.

The two entrepreneurs opened their stores which were no frills warehouses. Products

varied from well known national brands to propriety Home Depot brands.

Home Depot held its IPO in 1981 and listed on the New York Stock Exchange three years

later.

In 1997, however, Blank succeeded Marcus as CEO of the company, with Marcus

remaining as chairman.

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In 1999 Home Depot acquired a company named Georgia Lighting a specialty lighting

designer, distributor and retailer.

In 1998 it opened two stores in Chile and on in Pueto Rico

PRODUCTS & SERVICES

The Home Depot provides various product and services, including:

Home Improvement Goods

Rental services

Installation services

Appliances

CUSTOMER SEGMENTATION

Home Depot has three distinct customer segments. Since the company’s incorporation, they have

been primarily focused with the Do-It-Yourself (DIY) customers. These customers are non-

professional consumers interested in doing their own home improvement projects. More

recently, Home Depot has also begun to redefine the market in which they operate. This

redefinition has opened up the buy- it-yourself and professional customer segments to Home

Depot. Specifically the buy-it-yourself customer segment are those consumers that like to pick

out the materials being used in their homes, but want a professional to install them. Moreover the

professional customer segment that Home Depot now associates it with is contractors,

electricians, plumbers, landscapers, etc. This group has been able to get Home Depot to offer

products in larger quantities due to their larger scale projects. Recently they have started to serve

heavy industrial sector customers.

.

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CHAPTER 03ANALYSIS OF THE ECONOMY

ANALYSIS OF THE ECONOMY

MACROECONOMIC ANALYSIS

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The macroeconomic analysis of a company is in the response to the belief that company future

earnings, growth and stock prices are heavily affected by money supply, interest rates, taxing,

government spending and other economic indicators such as consumer expectations,

unemployment, productivity, domestic and foreign legislation, gross domestic product(GDP)

growth and capacity utilization that is output by the firm. Security market also reflects what is

expected to go in the economy, because the value of an investment is determined by its expected

cash flows and its expected required rate of return. Both of these valuation factors are influenced

by the aggregate economic environment.

ECONOMIC ACTIVITY AND HOME DEPOT STOCK PRICES

Stock prices consistently turn before the economy does. On October the company’s stock prices

dropped to $35. The reason behind this was that stock prices reflect expectations of earnings,

dividend and interest rates. As investors of Home Depot securities attempted to estimate their

future variables, their stock price decisions reflect future economic activity not current and past.

As Home Depot announced that their earrings will be lower for the next few quarters and there

was a possibility of slowing economic activity. During the period in which Home Depot had

existed, the home improvement industry in U.S. had grown at an annual rate of about 6 percent

or slightly slower than the U.S. economy as a whole. But in June 2000, with expectation of some

slowing in the economy, Home Depot their nominal growth will be lower over the next several

years. That is why company EPS and subsequently stock price would fall down.

MONETARY POLICY, THE ECONOMY AND STOCK PRICES

Declines in the growth rate of money supply have preceded business contraction while increases

in the growth rate of money supply have consistently preceded economic expansion. The Federal

Reserve controls the money supply through various tools, the most useful of which is open

market operations. Since 1992 the U.S. economy had experienced consistent growth. But June

1999 and May 2000, however, the Federal Reserve had raised interest rates six times- for a total

of 1.75 percentage points- in an effort to slow the economy and softening overall consumer

demand. To slow down the overall consumer demand Federal Reserve declined the growth rate

money supply, Federal Reserve sold bonds to reduce banks reserves and the money supply. For

the reduced money supply commercial banks got less opportunity give potential investor and

home owners. Reduced money supply reduced the home ownership and discretionary income

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and result in weak housing turnover. During the recession of 1990-1991 Home Depot

experienced only a small decline in sales, but at that point it occupied a far smaller share of the

market. As Home Depot market share increased the impact of reduced money supply that is

Federal Reserve step to slow down consumer demand affected the company sales that result in

decline in the stock prices. As Federal Reserve planned to continue it next several there is a

possibility of declining hosing owner ship and discretionary income that will significantly reduce

the EPS, growth and with a low expectations of dividend stock prices will decline as well.

INFLATION, INTEREST RATES AND STOCK PRICES, GROWTH, EARNINGS

The relationship between inflation, interest rates and stock prices is not direct and consistent. The

reason is that the cash flows from stocks can change along with inflation and interest rates and

we cannot be certain whether this change in cash flows will augment or offset the change in the

interest rates. Inflation and interest rates had very negative impact on Home Depot stock prices,

growth and earnings. A recent rise of inflation that was result in an increase in interest rates was

caused to decline cash flows because the inflation that caused the rise in interest rates had a

negative impact on earnings. During 1999 and 2000, interest rates increased and that caused

economic decline and sales and earnings to decline. On the other hand a period of inflation

wherein the costs of production increased, but Home Depot was not able to increase prices,

which caused a decline in profit margins. The impact of this set of event was become more

disastrous when stock prices had experienced a significant decline because k increased as g

declined, causing a large increased in the k-g spread. In future Home Depot can make the

scenario with an increase in prices of its products for additional cost due to inflation. In this case,

stock prices might be fairly stable because negative effect of an increase in the required rate of

return (k) is partially or wholly offset by the increase in the growth rate of earnings and

dividends(g), which means that the return on stock increase in line with the rate of inflation.

OTHER ECONOMIC INDICATORS AND ITS POTENTIAL IMPACT ON HOME DEPOT’S GROWTH & PROFIT

Home Depot currently has limited scale foreign operation but company’s plan to increase its

international operation could be seriously affected by foreign country economic framework as

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well as potential currency exchange risk. Future unemployment problems can decrease as well as

increase the company’s overall growth rates.

Productivity of labor can also be a good example potential growth or decline. GDP can play a

significant role in future growth and earnings.

Future growth and prospect will also be increased if Home Depot able to utilize its full capacity.

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CHAPTER 04INDUSTRY ANALYSIS

INDUSTRY ANALYSIS

The industry to which Home Depot Inc. belongs to expects the following growth rates over the

years 2000 to 2004:

Year Projected Growth in the US Market for Home Improvement Products

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2000 6.3%

2001 3.2%

2002 4.0%

2003 4.4%

2004 4.6%

2000 2001 2002 2003 20040.00%1.00%2.00%3.00%4.00%5.00%6.00%7.00%

Projected Growth in the US Market for Home Im-provement Products

Projected Growth in the US Market for Home Improvement Products

The US retail industry for home improvement products show a cyclical pattern as the stock

prices were low throughout the year 2000 whose primary reason is considered to be the slowing

US economy. It means the retail industry for home improvement products moves with or follows

the economic trend of the US economy resulting in the cyclical pattern of the industry.

INDUSTRY ANALYSIS OF HOME DEPOT INC. IN THE PORTER’S F IVE FORCES FRAMEWORK:Porter’s Five Forces model can be used as a tool to analyze the industry of Home Depot, Inc.

Five Forces Analysis assumes that there are five important forces that determine competitive

power in a business situation. These are:

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The Threat of The Entry of New Competitors

The Intensity of Competitive Rivalry

The Threat of Substitute Products or Services

The Bargaining Power of Customers (Buyers)

The Bargaining Power of Suppliers

These forces are used to analyze the US retail home improvement products industry:

THE THREAT OF THE ENTRY OF NEW COMPETITORSHome Depot Inc. the largest retailer of home improvement products in the United States

possesses almost 24 percent of the total market share of home improvements product. Home

Depot operated 930 stores spread over United States and Canada and has plans to reach the target

of having over1900 stores by the end of 2003. Recent data suggests that the recently opened

stores were in the existing markets to increase customer service levels and enhance long term

market penetration. Home Depot’s principal competitor Lowe’s had 576 stores at the end of

1999 and planned to add 78 new ones in 2000 in the existing market. So the competition in the

home improvements products’ market was high. In this situation it is quite difficult for a new

entrant to capture the market. A new entrant must have extremely strong competitive advantage

to penetrate the market to which Home Depot belonged. So, for Home Depot Inc. threat of the

entry of new competitors was fairly low.

THE INTENSITY OF COMPETITIVE RIVALRYThe competition that Home Depot Inc. faces is quite intense. Lowe’s is considered to be the

principal competitor of Home Depot Inc. having $16 billion as annual sales. At the end of 1999

Lowe’s was operating 576 stores and had plans to open 78 new ones in 2000. Lowe’s is the

second largest home improvement retailer in the world just behind Home Depot Inc. Lowe’s

copied Home Depot’s business model and made its stores more attractive to the customers.

Lowe’s also sold many products which Home Depot was not offering. In certain markets Lowe’s

was competing neck to neck with Home Depot and opened a few stores within the virtual eye

sight of Home Depot’s stores creating much difficulty for them to sell their products.

Menards and HomeBase a firm that was more focused geographically was considered to be the

next largest competitor of Home Depot although it was a far smaller company. Menards and

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HomeBase had a loyal customer base that allowed it to have 35% of the market share of the

home improvement products whereas Home Depot had only 15% in certain areas in the year

1998.

Although Home Depot is the market leader in terms of having the competitive advantage of

implementing a successful business model, its competitors follow them quickly eliminating its

competitive edge over its competitors. It indicates an intense competitive rivalry in the US retail

home improvement products’ industry. Home Depot Inc. has less bargaining power over its

competitors as it was facing a tough fight from its competitors.

THE THREAT OF SUBSTITUTE PRODUCTS OR SERVICESHome Depot provides its customers with best quality products at a relatively competitive price.

Home Depot’s core products are home improvement products. As long as there are homes,

improvements will be needed. Substitute of home improvement products can be if people stop

improving their homes and start purchasing new homes instead. But this is a very rare

possibility. For Home Depot Inc. the threat of substitution is not a huge factor.

THE BARGAINING POWER OF CUSTOMERS (BUYERS)Customers had a huge role in the products that Home Depot offered. Every time Home Depot

wanted to introduce a new product or service, it was done as an experiment to check the reaction

of the customers. Home Depot’s main concern was always the customer needs. Starting from the

products they designed to the store format was decided on the basis of customer needs and

reaction to experiments. To serve the customer needs it changed its strategy of serving only

nonprofessionals to a triple customer strategy which included installation services and serving

professionals as well as nonprofessionals. To mitigate the need of the customers it also plans to

introduce Internet Sales. So, the customers have a great impact on the operating style and

decisions of Home Depot Inc. Home Depot planned to expand its business in the same market

and for this reason the customer group concentration was limited within that market. It enabled

the customers to have more impact on Home Depot’s activities. The customers’ bargaining

power is higher.

THE BARGAINING POWER OF SUPPLIERS

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Home Depot is the largest retailer of home improvement products and possesses a huge portion

of total market share. As such suppliers of Home Depot largely depend on them. To be more

efficient, Home Depot acquired two firms of its suppliers. To provide Installation services Home

Depot arranged for approximately 6,200 third party contracts for which it collected fees. So,

Home Depot has a greater bargaining power over its suppliers.

The next section summarizes the US retail home improvement products industry to which Home

Depot belong, in the Porter’s Five Forces Framework.

US RETAIL HOME IMPROVEMENT PRODUCTS INDUSTRY IN THE PORTER’S FIVE FORCES FRAMEWORK:

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This graphical illustration indicates that competitive rivalry and customers’ bargaining power

pose grave threat to the industry, while other three factors pose less threat to this industry.

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Less Threat of The Entry of New Competitors

CHAPTER 05COMPANY ANALYSIS

COMPANY ANALYSIS

SWOT ANALYSIS

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Analysis of a company includes the analysis of the company’s internal and external factors. To

analyze these factors SWOT analysis is used. SWOT Analysis of Home Depot Inc. illustrates the

strengths, weaknesses, opportunities and threats of the company.

SWOT ANALYSIS OF HOME DEPOT INC.STRENGTHS

The Home Depot brand name itself is a significant strength.

Home Depot controls approximately 20% of the home improvement market.

Customer Satisfaction

Innovation

Financial Stability

Economies of Scale

Leadership

Stable Cash Flow

WEAKNESSES

Stores are not geared toward attracting female customers, who make most

Household buying decisions

Declining stock prices

Rising costs

OPPORTUNITIES

Untapped heavy industrial sector

North American growth potential

Service sector

THREATS

Slowing economy

High interest rates

Potential lower industry growth rate

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GRAPHICAL ILLUSTRATION OF SWOT ANALYSIS

ESTIMATING GROWTHCOMPANY GROWTH RATE

Dividend per share

Earnings per share

Dividend payout ratio

Retention ratio

ROE Growth

(1) (2) (3)=(1)/(2) (4)=1-(3) (5) (6)=(4)*(5)

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OpportunitiesUntapped heavy industrial sectorsNorth American growth potentialHuge service sectorsInternational ExpansionThreats Economic SlowdownHigh Interest Rates High Competition

1999 0.1088 1.00 0.1088 0.891119 .265 0.236146

1998 0.0724 0.71 0.1019 0.898009 .227 0.203848

1997 0.0607 0.52 0.1168 0.883119 .195 0.172208

DIVIDEND GROWTH RATE

Let assume, D0= $139 million dividend in 1998 and D2=$ 255 million dividend in 2000. By

using the formula we get the average dividend growth rate is 35.44%.

2√ 255139

−1=0.3544491

IMPACT OF THE GROWTH INITIATIVE ON COMPANY’S GROWTH RATECUSTOMER GROUPS:

Buy-it-Yourself Customers:

Key points of this customer group are summarized below:

These people choose Products but Installed by Third-Party

6,200 third-party contractors is arranged by the company

Aging demographics creating opportunity for market expansion.

Market for installation services estimated at $75 billion.

Less than 2% of the installation market.

Expected to grow by 40% each year for the next five years.

The initiative of increasing number of services offered to the buy it yourself customers will be

having positive impact of growth rate. As the market size for installation services is large and

this customer segment is less exposed to cyclical changes, it will definitely have a positive

impact on growth rate.

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Professional Customers:


Large Market potential

‘Job Lot’ quantities

Different needs for different customers

Effect of professional customers on DIY

Anticipated to influence sales the most out of all of the initiatives

More cyclical then DIY business

Expanding market share for professional customers unveiled another opportunity for the

company. This market emerges as the most profitable and largest market. Unique strategy is

needed to capture this market and cyclical characteristics will set challenges before the company.

Nevertheless this market segment will have positive impact on the company growth rate.

STORE FORMATSKey points of this customer group are summarized below:

Extending into specialty shops

Very high end product range

Required retainer fee

Sales goal for each customer ($10,000)

Investigating smaller stores to compete more directly with Home Hardware etc.

The store format home depot Inc is experimenting do not fully compatible with current business

plan and strategy. Two focused customer group cannot be well served with such store formats.

Maintenance cost of Expo design center stores will be higher than others warehouse stores.

Again economy is supposed to be slowdown. It will lead the customers choosing products which

costing lower. On the other hand direct competitions can slower the sales potentiality of the

small stores.

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PRODUCT CATEGORIES


Increasing product lines

Adding appliances to complement current offerings

Vertically integrate supply chain

Tool rentals and truck rentals

Expansion of rental services and current offering of appliances definitely make the Home depot

Inc an affectionate destination for shopping having positive effect on firm’s growth rate.

INTERNATIONAL GROWTH


Expansion into South America

Joint venture in Chile

Looking into expansion into the Far East

Entering into international market will make the firm more exposed to the exchange rate risk.

Again differences in culture and customer needs will create more difficulties in managing

venture and create a strong position in market.

INTERNET SALES


Information centre for customers

Adding e-commerce abilities

Intended to complement brick stores

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Extending business operations through internet will dignify the corporate image and facilitate

customers with pre shopping information. Along with raising operational cost it will have a

positive impact on the growth rate.

SALES FORECAST AND NOPAT GROWTH RATE

Year Sales Sales growth NOPAT NOPAT growth

2000 42563.45 0.262369 2511.111 0.429385

2001 48392 0.136938 2918 0.162035

2002 54220.56 0.120445 3324.889 0.139441

2003 60049.11 0.107497 3731.778 0.122377

2004 65877.67 0.097063 4138.667 0.109034

2005 71706.23 0.088475 4545.555 0.098314

2006 77534.78 0.081284 4952.444 0.089514

2007 83363.34 0.075173 5359.333 0.082159

To forecast sales and NOPAT we use double moving average technique. By analyzing data we

can conclude that there is a possibility of declining growth rate of earnings in future. Again, we

can say that this is the state of the firm which induced the firm to take growth initiatives to

increase its company growth rate. Considering the initiative taken by the firm we expect the firm

will be enabling to achieve a greater growth rate then our forecasted value. So, here we are

considering these values as the minimum rate which can be attained by the firm even without any

growth initiatives.

SUMMARY OF THE OBSERVATION

Growth initiatives Impact on earnings Impact on stock price

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growth

Customer groups + +

Store Formats - -

Product Categories + +

International Growth + +

Internet Sales + +

Growth rate

Average dividend growth rate 35.44%

Simple Annual sales growth rate 32.45%

Simple Average NOPAT growth 40.53%

Current company growth rate 23.61%

Growth range for year 2000 23.61% to 35.44% and declining there after

ESTIMATED GROWTH RATE

After considering all the facts mentioned, we are expecting a moderate earnings growth rate over

the next few years because of a slow economy. Again we assume that effect of competitive

advantages and the growth initiatives will be sustaining for a definite time period. As a result in

absence of any new strategy growth rate will be declining in later years. For our valuation

purpose we assume that the growth will remain unchanged for the years afterward.

Year Growth rate (%)

Normal Optimistic Pessimistic

2001 24 25 22

2002 24 25 22

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2003 24 25 22

2004 24 25 21

2005 24 24 21

2006 23 24 19

2007 22 24 18

2008 21 23 17

2009 18 20 16

2010 16.5 17 16

ASSUMPTIONSOPTIMISTIC

Affirmation Negation

Favorable industry growth because of Low

interest rate, strong housing turnover, rising

home ownership and increases in discretionary

income.

Continued growth with Do It Yourself Business

Successful expansion of stores and product

categories will lead toward a high sales volume.

40% growth in Buy It Yourself Customers.

Growth with Professional Customers with high

margin.

Rise in Federal Reserve interest rate.

Slowdown in economy and squeeze

in consumer spending.

High competition.

As interest rate on mortgage loan is low, it is creating a favorable market condition for Home

Depot. We are also expecting a rise in growth rate in later years. As both the average dividend

and NOPAT growth is higher, it implies having a high growth rate potentiality in future. Again,

company is planning to add new stores. Market of home depot products is growing too. This

favoring external situation will help to implement their growth strategies more accurately. When

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starting phase of the growth initiatives lead the growth rate rising, expansion of these strategy

and their ending result must be ameliorating. The company will be able to expand market share

and capture more and more customers. All these fact will lead earning growth rate raising later

future.

MOST LIKELY


Slow economy will slow down the

company growth rate, less so with

Professional customers.

Some success with in Buy it Yourself

Customers.

Extension of products, services, and

stores- allows some growth with the Do

it Yourself Customers.

Difficult to manage.

High probability of reduction in

employee quality and customer

satisfaction.

Higher cost of capital due to rise in

interest rate.

PESSIMISTIC


Some continued growth with Do It Yourself

Business via store expansions & bundling.

Moderate success in Buy it Yourself

Customers.

Difficult to cross over with the Professional

Customer base.

Sustaining competitive

advantage due to differentiation

strategy.

As a growth company, home depot will keep growing in future. It is following differentiation

strategy, which enables it to maintain its strong position in market. But as the economy will be in

squeezed position over next few years, company will be unable to attain a higher growth rate.

And later competitors will imitate their strategy lowering their market share. Considering this

fact the growth rate will be even lower in future.

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PROBABILITY OF OUTCOMESConsidering all possible situation we assigned the following weights to the possible outcomes.

Optimistic .3

Most likely .6

Pessimistic .1

RATE OF RETURNRisk free rate of return(RFR) 6.18% (yields on 90 day treasury securities)

Home Depot’s beta(β) 1.09

Market return(Rm) 16.39% GM of last 9 year S&P 500 return on stock

CAPM MODEL

Using this model we got the following estimations:

Market Risk premium 10.21% (Rm- RFR)

Risk premium 11.13% β (Rm- RFR)

Expected rate of return(k) 17.31% RFR + β (Rm- RFR)

ASSIGNING WEIGHTSWACC

Cost of equity (Ke) 17.31%

Cost of debt (Kd) 4.8% mortgage interest rate in fall after tax

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E(R) = RFR + β (Rm- RFR)

Weight (We) .92

Weight (Wd) .08 (long term debt + capital lease)

Tax 40%

WACC 16.31

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Stock valuation

Present Value Of Dividends Model (DDM)Applying the DDM model with the values of g, k and D estimated in previous section, here we

estimate the stock price of stock price of Home Depot for year 2000. dividend in year 1999 is

considered as D0.

MOST LIKELY OUT COMES

Here, D0 = $0.1089, k= 17.31%, and the estimated most likely growth rates are considered as

values for g.

Year D g Dividend per share

Present value factor17.31% Present value

2001 1 0.24 0.133947 0.852442 0.114182

2002 2 0.24 0.166094 0.726658 0.120694

2003 3 0.24 0.205957 0.619434 0.127577

2004 4 0.24 0.255387 0.528032 0.134852

2005 5 0.24 0.316679 0.450116 0.142543

2006 6 0.23 0.389516 0.383698 0.149456

2007 7 0.22 0.475209 0.327081 0.155432

2008 8 0.21 0.575003 0.278817 0.160321

2009 9 0.18 0.678503 0.237676 0.161264

2010 10 0.165 0.790457 0.202605 0.16015

Constant growth period value = 0.790457∗(1.165)

0.1731−0.165=$22.9351

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1. Present value of dividends$1.426470012

2. Present value of constant growth period dividends$22.9351

Total present value of dividends $24.36157

OPTIMISTIC OUTCOMESHere, D0 = $0.1089, k= 17.31%, and the estimated optimistic growth rates are considered as

values for g.

Year D g Dividend per

share

Present value

factor17.31%

Present

value

2001 1 0.25 0.136125 0.852442 0.116039

2002 2 0.25 0.170156 0.726658 0.123645

2003 3 0.25 0.212695 0.619434 0.131751

2004 4 0.25 0.265869 0.528032 0.140387

2005 5 0.24 0.329678 0.450116 0.148393

2006 6 0.24 0.4088 0.383698 0.156856

2007 7 0.24 0.506912 0.327081 0.165801

2008 8 0.23 0.623502 0.278817 0.173843

2009 9 0.2 0.748203 0.237676 0.17783

2010 10 0.17 0.875397 0.202605 0.17736

Constant growth period value = 0.875397∗(1.17)0.1731−0.17

=$ 66.93897

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1. Present value of dividends$1.511905

2. Present value of constant growth period dividends$66.93897


PESSIMISTIC OUTCOME

Here, D0 = $0.1089, k= 17.31%, and the estimated pessimistic growth rates are considered as

values for g.

Year D g Dividend per share

Present value factor17.31%

Present value

2001 1 0.22 0.132858 0.852442 0.113254

2002 2 0.22 0.162087 0.726658 0.117782

2003 3 0.22 0.197746 0.619434 0.12249

2004 4 0.21 0.239272 0.528032 0.126343

2005 5 0.21 0.28952 0.450116 0.130318

2006 6 0.19 0.344528 0.383698 0.132195

2007 7 0.18 0.406544 0.327081 0.132973

2008 8 0.17 0.475656 0.278817 0.132621

2009 9 0.16 0.551761 0.237676 0.13114

2010 10 0.16 0.640043 0.202605 0.129676


0.1731−0.16=$ 11.48273

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1. Present value of dividends $1.2687912. Present value of constant growth period dividends $11.48273


EXPECTED SHARE PRICEOutcomes Probability Share Price

Most Likely 0.6 24.36157 14.61694

Optimistic 0.3 68.45088 20.53526

Pessimistic 0.1 11.48273 1.148273

Expected Share Price 36.30047

PRESENT VALUE OF FREE CASH FLOW TO EQUITYThis techniques attempts to determine the free cash flow that is available to the stock holders

after payments to all other capital suppliers and after providing for the continued growth of the

firm. Definition of free cash flow to equity (FCFE) is:

Value = FCFEk−g

Here, we applied the formula assuming super normal growth rates estimated earlier. FCFE in

period 2000 was $ 409 million. So, stock price = present value of cash flows/number of shares.

MOST L IKELY OUT COMES

Here, FCFE0 = $409 million, k= 17.31%, and the estimated most likely growth rates are

considered as values for g.

Year Period Growth

rate

FCFE Present value

factor17.31%

Present

value

2001 1 0.24 507.16 0.852442 432.3246

2002 2 0.24 628.8784 0.726658 456.9794

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Net income + Depreciation expense - capital expenditure e- change in working capital - principal debt payments + new debt issues

2003 3 0.24 779.8092 0.619434 483.0402

2004 4 0.24 966.9634 0.528032 510.5872

2005 5 0.24 1199.035 0.450116 539.7051

2006 6 0.23 1474.813 0.383698 565.883

2007 7 0.22 1799.271 0.327081 588.5067

2008 8 0.21 2177.118 0.278817 607.0183

2009 9 0.18 2569 0.237676 610.5887

2010 10 0.165 2992.885 0.202605 606.3727

Constant growth period value = 2992.885∗(1.165)0.1731−0.165

=$ 87212.86 million

OPTIMISTIC OUTCOMES

Here, FCFE0 = $409 million, k= 17.31%, and the estimated optimistic growth rates are


Year Period Growth rate

FCFE Present value factor17.31%

Present value

2001 1 0.25 511.25 0.852442 435.8111

2002 2 0.25 639.0625 0.726658 464.3797

2003 3 0.25 798.8281 0.619434 494.8211

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1. Present value of cash flows $ 5401.006 million2. Present value of constant growth period cash flows $ 87212.86 million

Total present value of cash flows $ 92613.86763 millionStock price $ 39.54478

2004 4 0.25 998.5352 0.528032 527.2581

2005 5 0.24 1238.184 0.450116 557.3267

2006 6 0.24 1535.348 0.383698 589.1102

2007 7 0.24 1903.831 0.327081 622.7062

2008 8 0.23 2341.712 0.278817 652.9099

2009 9 0.2 2810.055 0.237676 667.8816

2010 10 0.17 3287.764 0.202605 666.1166


0.1731−0.17=$ 251405.3 million

PESSIMISTIC OUTCOMEHere, FCFE0 = $409 million, k= 17.31%, and the estimated pessimistic growth rates are


Year Period Growth

rate

FCFE Present value

factor17.31%

Present

value

2001 1 0.22 498.98 0.852442 425.3516

2002 2 0.22 608.7556 0.726658 442.357

2003 3 0.22 742.6818 0.619434 460.0422

2004 4 0.21 898.645 0.528032 474.5129

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2005 5 0.21 1087.36 0.450116 489.4388

2006 6 0.19 1293.959 0.383698 496.4898

2007 7 0.18 1526.872 0.327081 499.41

2008 8 0.17 1786.44 0.278817 498.0903

2009 9 0.16 2072.27 0.237676 492.5281

2010 10 0.16 2403.833 0.202605 487.0281


0.1731−0.16=$ 43126.15 million

EXPECTED SHARE PRICEOutcomes Probability SP E(SP)

Normal 0.6 39.54478 23.72687

Optimistic 0.3 109.771 32.93129

Pessimistic 0.1 20.44893 2.044893

Expected Share Price 58.70305

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SUMMARIZATION OF THE VALUATIONS: ESTIMATED STOCK PRICE

The market price of stock of Home Depot Inc currently is $35 while the PV of Dividends is

estimated to be $ 36.30. The Present Value of FCFE is $ 58.703. It is the amount that Home

Depot can afford to pay as dividend per share. It indicates that the expected dividend payment

from the stocks of Home Depot Inc. is higher than the current market price. So, currently the

stock of Home Depot is undervalued and the stocks seem to be growth stocks. It will be a wise

decision for the investors to purchase the stocks of Home Depot now.

RELATIVE VALUATION TECHNIQUESEarnings ($ millions)

Cash flow($ millions) Sales($ millions)

Values in 1999 2320 168 38434

Estimated values in 2000

2879.12 208.488 47696.59

Values per share 1.23 .089 20.37

RELATIVE VALUATION RATIOSP/E ratio P/CF2000 P/S2000

Present value of dividends

29.5122 407.7674 1.782404

Present value of FCFE

47.74797 659.4261 2.882437

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P/E Ratio measures the price paid for a share relative to the annual net income or profit

earned by the firm per share. The P/E ratio of Home Depot Inc. calculated based on the

PV of dividends is 29.5122. It is estimated that Home Depot’s earnings to be 29.5122

times its share price. While P/E ratio based on the PV of FCFE is 47.74797 indicating the

earnings to be 47.74797 times the share price. Home Depot’s shares have a very high

P/E. Investors can expect a high future growth in earnings.

P/CF ratio is a ratio used to compare a company's market value to its cash flow. The P/CF

ratio calculated based on PV of Dividends is 407.7674 and P/CF calculated based on PV

of FCFE is 659.4261. The P/CF is similar to a company's P/E ratio, but it does not take

into account earnings that have not actually been received. P/CF ratio allows its users to

assess risk relative to the company's cash on-hand, instead of the cash it ought to have.

When compared to P/CF ratios of other firm, the lower the P/CF is, the better value that

stock is.

P/S ratio is the ratio of a stock's price to its per-share sales. This ratio is used to find

whether a stock's current market price is expensive or cheap. A low price to sales ratio

(below 1.0) is usually thought to be a better investment since the investor is paying less

for each unit of sales. The P/S ratio based on PV of Dividends of Home Depot is 1.78 and

P/S ratio calculated based on PV of FCFE is 2.88. The P/S ratio of Home Depot is higher

than one. But whether investment in Home Depot’s share is good or not must be decided

by comparing the P/S ratio of other firms in the same industry.

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DU PONT ANALYSISThe return on investment (ROI) ratio is used by many firms to evaluate how effectively assets

are used. The ROI of Home Depot Inc. for the year 2000 is:

¿ 2511.11147696.59

× 47696.5921197.521

=0.1185

The return on equity (ROE) ratio is a measure of the rate of return to stockholders. Du Pont

Analysis decomposes the ROE into various factors influencing company performance. The ROE

of Home Depot Inc. for the year 2000 is:

¿ 2511.1113515.56

× 3515.563543.56

× 3543.5647696.59

× 47696.5921197.521

× 21197.52112341

=0.2034

Where,Net profit = net profit after taxesEquity = shareholders' equityEBIT = Earnings before interest and taxesSales = Net sales

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RATIO ANALYSIS Profit Margin or Net Profit Ratio: a measure of profitability calculated by finding

the net profit as a percentage of the revenue. The profit margin is mostly used for internal

comparison. The profit margin ratio of Home Depot Inc. in 2000 is:

Profit Margin Ratio= Net ProfitPretax Profit

=2511.1113515.56

=0.714

Home Depot Inc. has a net income of 0.714 dollars for each dollar of sales.

Asset Turnover Ratio: a financial ratio that measures the efficiency of a company's use

of its assets in generating sales revenue or sales income to the company. Asset Turnover

ratio is calculated by dividing average total assets by net sales. The asset turnover ratio of

Home Depot Inc. for the year 2000 is:

Asset Turnover Ratio= SalesAssets

= 47696.5921197.521

=2.25

Home Depot has an asset turnover ratio of 2.25 which is high indicating a low profit

margin because of competitive pricing.

Leverage Ratio: measures a company’s ability to meet its financial obligations. The

leverage ratio of Home Depot Inc. in the year 2000 is:

Leverage Ratio= AssetsEquity

=21197.52112341

=1.72

Home Depot’s Leverage ratio is 1.72.

RISK ANALYSIS44 | P a g e

MEASURESMEASURES OFOF RISKRISKRANGE OF GROWTH

Year Optimistic growth rate Pessimistic growth rate Range

2001 0.25 0.22 0.03

2002 0.25 0.22 0.03

2003 0.25 0.22 0.03

2004 0.25 0.21 0.04

2005 0.24 0.21 0.03

2006 0.24 0.19 0.05

2007 0.24 0.18 0.06

2008 0.23 0.17 0.06

2009 0.2 0.16 0.04

2010 0.17 0.16 0.01

In the table above growth can vary year to year by range mentioned in the last column.

STANDARD DEVIATION1

Standard deviation is a measure of the variation of possible outcomes from the expected

outcomes. The larger the standard deviation, the greater the dispersion of expected outcomes and

the greater the uncertainty. In the table below we have shown standard deviation for the

forecasted values for earnings, cash flow and sales.

Earnings ($ millions) Cash flow ($ millions) Sales ($ millions)

541.14 39.42 8964.80

BETA VALUEBeta represents the covariance of returns with the market portfolio. Here company beta = 1.09. it

indicates that if market return increases by 1%, company’s return will increase by 1.09% and

vice versa.

1 Calculations are shown in appendix

45 | P a g e

Range = optimistic outcome – pessimistic out come

SENSITIVITY TOWARD STOCK PRICE DUE TO CHANGE IN DIVIDENDS

change in stock pricechange in DPS

=3.70.0112

=330.36

SENSITIVITY ANALYSISIn this section we will analyze company’s stock price sensitivity toward change in some input variables.

Variables to be changed:

Required rate of return Dividends Free cash flow to equity

C H A N G E I N D I V I D E N D

In the table below, changes in stock price using Dividend Discounting Model due to changes in

amount of dividend to stock holders.

Dividend per share ($) Stock price($)

PV OF DDM PV OF FCFE

Base case 0.1088 36.30 58.703

increase 0.12 40 58.703

Decrease 0.08 26.67 58.703

INTERPRETATION : IF THE DIVIDEND INCREASES BY $1, COMPANY’S STOCK PRICE WILL INCREASE BY $330.36

C H A N G E I N R E Q U I R E D R A T E O F R E T U R N

REQUIRED RATE OF RETURN

STOCK PRICE ($)

PV OF DDM PV OF FCFE

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SENSITIVITY TOWARD STOCK PRICE DUE TO CHANGE IN REQUIRED RATE OF RETURN

= change∈stock pricechange∈required rate of return

SENSITIVITY TOWARD STOCK PRICE DUE TO CHANGE IN FREE CASH FLOW TO EQUITY

= change∈stock pricechange∈ freecash flow ¿

equity ¿ =0.1436

BASE CASE 17.31% 36.30 58.703

INCREASE 18% 15.72 48.42

INTERPRETATION : CHANGE IN REQUIRED RATE OF RETURN WILL AFFECT BOTH OF THE PRICES . IF THE REQUIRED RATE OF RETURN INCREASES BY 1%, COMPANY’S STOCK PRICE WILL DECREASE BY $2982.61 USING THE DDM MODEL AND $1489.86 USING THE FCFE MODEL .

C H A N G E S I N F R E E C A S H F L O W T O E Q U I T Y

F RE E C AS H F LOW TO EQU IT Y ($)

STOC K P RI CE ($)

PV O F DDM PV O F FCFE

BA SE C AS E 409 36.30 58.703

IN CR EA S E 489 36.30 70.19

DEC R EA SE 289 36.30 41.48

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PV of DDM

−20.58.0069

=−2982.61

PV of FCFE

−10.28.0069

=−1489.86

INTERPRETATION : IF THE FREE CASH FLOW TO EQUITY INCREASES BY $1, COMPANY’S STOCK PRICE WILL INCREASE BY $0.1436.

CHANGE IN GROWTH RATECHANGE IN COMPANY’S ESTIMATED GROWTH RATE CAN CHANGE THE STOCK PRICE DRASTICALLY . A SLIGHT CHANGE IN GROWTH RATE AT YEAR 2010 CAN CHANGE STOCK PRICE TO A GREAT EXTENT .

SOURCESSOURCES OFOF RISKRISK

BUSINESS RISK

Business risk is the uncertainty of income flows caused by the nature of a firm’s business. In the

previous section calculation of standard deviation of earnings and sales has been shown. The

large values indicate that, there are large variations in estimated earnings and sales. So the firm is

operating a high business risk.

FINANCIAL RISK

Financial risk is the Uncertainty caused by the use of debt financing. As in current year firm is

operating at 17% financial leverage, we can say that the financial risk for the firm is moderate. If

the proportion of debt capital increases, firm’s financial risk will increase as well.

EXCHANGE RATE RISK

Exchange rate risk is Uncertainty of return is introduced by acquiring securities denominated in a

currency different from that of the investor. As the firm is planning for expansion in foreign

market, exchange rate risk will increase.

48 | P a g e

Company’s stock price is more sensitive towards growth rate and required rate of return.

COUNTRY RISK

The U.S economy had experienced uninterrupted growth since 1992. Assuming a stable political

state, firm’s exposure to country risk is lower.

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CHAPTER 06PROBLEM STATEMENT

POTENTIAL PROBLEMS OF THE COMPANY

NEGATIVE OPERATING FREE CASH FLOW

The object is to determine a value for the total firm and subtract the value of the firm’s debt

obligations to arrive at a value for the firm’s equity.

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While free cash flow doesn't receive as much media

coverage as earnings do, it is considered by some experts to

be a better indicator of a company's financial health.

Negative free cash flow is not necessarily an indication of a

bad company, however, since many young companies put a

lot of their cash into investments, which diminishes their

free cash flow. But if a company is spending so much cash,

it should have a good reason for doing so and it should be

earning a sufficiently high rate of return on its investments.

As the firm is expected to earn a high rate of return on

investment, there is higher probability of positive OFCF in

near future.

HIGH OPERATING LEVERAGEAt the end of 1999 the company owned 77% of its store and leased 23% of them. Again the

company planned to increase proportion of owned stores. This will cause rise in fix cost and a

high operating leverage. By leasing the store firm can reduce its operating leverage and there by

the operational risk.

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Operating free cash flow = EBIT (1-tax rate) + Depreciation expense - capital expenditure - change in working capital – change in other asset

Calculation of OFCF

EBIT (1-tax rate) 2299.2

Add : depreciation

expense

463

less: capital

expenditure

-2581

less: change in

working capital

-301

OFCF -119.8

CHAPTER 07RECOMMENDATION

RECOMMENDATION

Management of risk is important. But It is also important to choose cost effective approaches. If

the cost to eliminate the risk is higher than the potential loss, there is no point in spending more

to eliminating a risk. Often, it may be better to accept the risk than to use excessive resources to

eliminate it.

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RISK MAY BE MANAGED IN A NUMBER OF WAYS

BY USING EXISTING ASSETS:Here existing resources can be used to counter risk. This may involve improvements to

existing methods and systems, changes in responsibilities, improvements to

accountability and internal controls, etc.

BY CONTINGENCY PLANNING:

Home Depot may decide to accept a risk, but choose to develop a plan to minimize its

effects if it happens. A good contingency plan will allow Home Depot to take action

immediately, with the minimum of project control if Home Depot finds them in a crisis

management situation.

BY INVESTING IN NEW RESOURCES: Home Depot risk analysis gives it the basis for deciding whether to bring in additional

resources to counter the risk. This can also include insuring the risk: Here they may pay

someone else to carry part of the risk.

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case home depot

Documents

gains competitive advantages

york stock exchange

free cash flow

intensely competitive nature

constant growth period

asset turnover ratio

home improvement products

exchange rate risk