Fast growth, low yield
With The Home Depot, Inc. (NYSE:HD)’s dividend yield sitting at 2.23% the dividend needs to grow quickly in the future in order to justify an investment. The company has stated that it aims to have a payout ratio of 50%, and with the new increased dividend the payout ratio using 2012 net income is just a hair above this 50% mark. Measured relative to the free cash flow the payout ratio is a lower 41%. Over the past decade the dividend grew at 20% annually, but this was driven largely by an expansion of the payout ratio. Since 2003 EPS has only grown at an annualized rate of 5.3%, so indeed most of the dividend growth was a result of upping the payout ratio. Now that the 50% target has been reached future dividend growth will only be as fast as earnings growth. And even with the effect of the buybacks this is only expected to be 12% next year.
How fast does the dividend need to grow to justify an investment? We can do a simple dividend discount calculation to find out. The total dividend in 2012 was $1.16 per share, and we know that 2013 will see a 34% dividend increase. Over the ten years after that, how fast does the dividend need to grow?
About 13.6% annually. Is this possible? The average analyst estimate for 5-year annual earnings growth is 14.51%, so this number is certainly within the realm of possibility. But remember that there isn’t really any room for an expansion of the payout ratio, so the 20% growth of the past is not going to repeat itself.
What about Lowe’s?
The Home Depot, Inc. (NYSE:HD) competitor Lowe’s Companies, Inc. (NYSE: LOW) saw its annual revenue climb only 0.62% in 2012, and its Q4 revenue actually declined by 5% year-on-year. Lowe’s pays a lower dividend that Home Depot, only a 1.66% yield, but with a payout ratio of just 36.7% there is ample room for expansion. Lowe’s trades at a similar P/E ratio of 22.7, but EPS has been boosted over the past two years by large share buybacks. Net income has actually shrunk since 2010, which is not the case for Home Depot. It seems that Lowe’s is relying far more heavily on buybacks to boost its bottom line than Home Depot, and without the buybacks EPS actually would have declined since 2010. With similar P/E ratios, Home Depot is the clear choice between the two.
The bottom line
Home Depot’s massive share buyback program comes at a time of a historically high valuation, leading me to believe that the effect of the program will not be positive for the company. It seems like an attempt to artificially boost the EPS, but even with the buyback growth will be too slow to justify a P/E ratio of 23. The dividend will certainly grow at a much slower pace than it did over the past decade, and with a yield of just 2.23% there are far better choices out there in terms of dividend stocks. Although a better choice than Lowe’s it looks to me that The Home Depot, Inc. (NYSE:HD)’s stock has risen too far too fast, and I would wait for a substantial decline before considering buying shares.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Lowe’s.
