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PulteGroup, Inc. (PHM), Hovnanian Enterprises, Inc. (HOV): Is Toll Brothers Inc (TOL) Destined for Greatness?

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Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Toll Brothers Inc (NYSE:TOL) fit the bill? Let’s take a look at what its recent results tell us about its potential for future gains.

What we’re looking for

The graphs you’re about to see tell Toll Brothers Inc (NYSE:TOL)’ story, and we’ll be grading the quality of that story in several ways:

1). Growth: Are profits, margins, and free cash flow all increasing?
2). Valuation: Is share price growing in line with earnings per share?
3). Opportunities: Is return on equity increasing while debt to equity declines?
4). Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you

Now, let’s take a look at Toll Brothers Inc (NYSE:TOL)’ key statistics:

TOL Total Return Price Chart

TOL Total Return Price data by YCharts.

Passing Criteria 3-Year* Change Grade
Revenue growth > 30% 43.3% Pass
Improving profit margin 305.60% Pass
Free cash flow growth > Net income growth (351.6%) vs. 394.8% Fail
Improving EPS 375.6% Pass
Stock growth (+ 15%) < EPS growth 75.7% vs. 375.6% Pass

Source: YCharts. *Period begins at end of Q2 2010.

TOL Return on Equity Chart

TOL Return on Equity data by YCharts.

Passing Criteria 3-Year* Change Grade
Improving return on equity 341.5% Pass
Declining debt to equity 0.20% Fail

Source: YCharts. *Period begins at end of Q2 2010.

How we got here and where we’re going

Toll Brothers Inc (NYSE:TOL) doesn’t come through with flawless performance, but five out of seven passing grades is a strong showing from the once-beleaguered housing sector. You could easily argue for a sixth passing grade based on functionally flat debt-to-equity levels over the past three years as well. However, Toll Brothers’ free cash flow has diverged from its net income over the past three years. Let’s dig a little deeper to see what Toll Brothers can do to improve this one weak spot

Many homebuilders such as Toll Brothers Inc (NYSE:TOL), PulteGroup, Inc. (NYSE:PHM), and Hovnanian Enterprises, Inc. (NYSE:HOV) are poised to capitalize on rebounding housing markets in the United States, which has finally begun to show signs of real life after trailing behind the market recovery. Fellow Fool John Maxfield points out that the housing market’s recovery has been driven by low interest rates and once-again attractive home prices, which compare favorably to increasing rental rates. Toll Brothers owns a large amount of land in urban areas, which will enable it to market its upscale offerings to a more well-heeled population. In an increasingly two-speed economy, that’s an advantage worth hanging onto.

My Foolish colleague Jason Hall notes that Toll Brothers should enjoy continued growth thanks to a solid backlog of about $2.4 billion in customer orders, with an average cancellation rate of less than 5% in recent quarters. Toll Brothers has clocked its luxury homes at an average price of $577,000 so far this year. The persistence of low interest rates — remaining at 4.4% this week, roughly half the historical average — will be important to Toll Brothers’ continued progress.

Industry peer Hovnanian Enterprises, Inc. (NYSE:HOV), which is a far smaller player compared to Toll Brothers and Pulte, has yet to recover quite as well from the housing bust. Quite recently, Hovnanian Enterprises, Inc. (NYSE:HOV) reported an 18% increase in unit deliveries, but Toll Brothers’ unit deliveries shot up by more than 33% year over year. Pulte’s unit deliveries increased, but its new orders fell by 12% on a year-over-year basis. Out of these three homebuilders, Toll Brothers seems to be putting together the most consistent recovery, even though Pulte is presently in the lead in terms of three-year share-price growth.

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