# The Home Depot, Inc. (HD), Lowe’s Companies, Inc. (LOW) & The Best Home Improvement Stock

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One group of companies which were hit particularly hard by the housing crisis were the home improvement companies, specifically The Home Depot, Inc. (NYSE:HD) and Lowe’s Companies, Inc. (NYSE:LOW). But as the housing market comes roaring back, these companies should be two of the greatest beneficiaries. How do you decide which stock is superior? Well, there are two steps to that process.

An operational comparison

Before looking at the valuations of each company it’s important to compare how the companies actually achieve their respective returns. One number that we could look at is the return on equity, but this single number isn’t enough. What we need to do is break down this value into its component parts, thus painting a clearer picture of each company’s operations. I’ll do this via a DuPont analysis.

What’s a DuPont analysis?

In the 1920’s the DuPont Corporation developed what became known as the DuPont analysis, a technique which uses basic accounting identities to break down the return on equity into either 3 or 5 component parts. I’ll be using the more detailed 5-component version. The basic equation is below:

This equation is an identity because everything on the right-hand-side cancels out except Net income divided by Equity. Each of the five items is a component which, when multiplied together, yields the ROE.

1. Net income/EBT – This is the company’s tax burden, or the proportion of a company’s earnings which remain after taxes. 100% would mean the company paid no taxes, while 0% would mean all EBT went to taxes.
2. EBT/EBIT – This is the company’s interest burden, or simply the percentage of EBIT remaining after interest is deducted. 100% would mean that the company paid no interest, while 0% would mean that all EBIT went to interest payments.
3. EBIT/Sales – This is the operating income margin, or return on sales.
4. Sales/Assets – This is the asset turnover, which represents the revenue as a percentage of assets. This can be over 100%.
5. Assets/Equity – This is the leverage ratio. The higher the number, the more leverage the company is using. A value of 1 represents no leverage.

By comparing these 5 numbers over time we can see what the driving force behind the ROE has been. And by comparing companies we can see exactly how they generate their ROE.

The calculation

Here’s all of the data required for the calculation for both The Home Depot, Inc. (NYSE:HD) and Lowe’s Companies, Inc. (NYSE:LOW):

Home Depot

Lowe’s

Data from Morningstar

One note: since the calculations mix values from the income statement and the balance sheet, and the balance sheet is a snapshot from the end of the year, I’ll take the average of the beginning-of-year and the end-of-year values for the balance sheet items. Here are the results:

Home Depot

Lowe’s

What does it all mean?

The first value from the results, the return on equity, shows a huge discrepancy between the two companies. In 2012 The Home Depot, Inc. (NYSE:HD) managed a 25% ROE, while Lowe’s managed an ROE of roughly half of that value. How are two companies that are so similar on the surface so different in terms of execution?

Thankfully, the DuPont analysis can answer that question. The tax burden of each company is about the same, as is the interest burden. But the interest burden does show a trend of The Home Depot, Inc. (NYSE:HD) paying less interest and Lowe’s paying more. Indeed, Lowe’s has increased its debt levels considerably over the past five years, while Home Depot has held its debt levels essentially constant. This gives Home Depot a bit of an advantage.

It starts to get interesting when we look at the EBIT margin. Since 2009 The Home Depot, Inc. (NYSE:HD) has been constantly improving this value, growing it from 7.26% to 10.39% most recently. Lowe’s, on the other hand, has been unable to boost its EBIT margin at all. In fact, Lowe’s best year in regards to this margin is barely higher than Home Depot’s worst year.

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