Home Depot Term Paper

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Home Depot is a major retailer in the United States specializing in home improvement supplies. Lowe's is a major competitor of Home Depot, being of similar size and scope, as well as having a similar business model. Home Depot is the larger of the two, and has more international operations, but these two firms make a great comparable of the financial statements of giant retailers because there are such strong similarities between the two. This report will feature the calculation of several key investment ratios, and this will be followed by qualitative analysis of the different factors surrounding the two companies. Lastly, there will be a recommendation about which of the two companies should be purchased by an investor.

Calculations.

There are several calculations that must be taken into account in order to conduct a full and proper financial analysis. This section will outline the key ratios for each of these firms in the key areas of profitability, liquidity, risk and performance. These calculations will be used as the basis of analysis in the second section of this report. The first category is the profitability ratios -- the gross margin, the operating margin and the net margin.

Home Depot

Lowe's

Profitability Ratios

Gross Income

25842

17327

Revenue

74754

50521

Gross Margin

34.57%

34.30%

Operating Income

Revenue

74754

50521

Operating Margin

10.39%

7.05%

Net Income

1959

Revenue

74754

50521

Net Margin

6.07%

3.88%

The second category is the liquidity ratios, which are the current ratio, the quick ratio and the cash ratio.

Home Depot

Lowe's

Liquidity Ratios

Current Assets

15372

Current Liabilities

11462

Current ratio

1.34

1.27

Quick Assets

Current Liabilities

11462

Quick ratio

0.41

0.15

Cash & equivalents

Current liabilities

11462

Cash ratio

0.22

0.09

The third category consists of the solvency ratios, which are the debt ratio and the debt to equity ratio. These are the measure of long-term risk with respect to the company, because they reflect the capital structure, which if too heavily weighted towards debt makes the future cash flows of the company riskier.

Home Depot

Lowe's

Solvency Ratios

Debt

23307

18809

Total Assets

41084

32666

Debt Ratio

56.73%

57.58%

Debt

23307

18809

Equity

17777

13857

Debt/Equity Ratio

1.31

1.36

The fourth category is the stock market performance. This category is important when considering an investment in the company. Metrics and charts illustrate stock market performance better than ratios do. The following table highlights some of the key metrics that might help compare the two companies

Home Depot

Lowe's

Current Price

78.94

51.95

Price Last Year

61.25

31.40

% change

+28.8%

+65.4%

Beta

0.87

1.22

EPS

$3.37

$1.97

Forward P/E

18.34

19.62

Dividend Yield

2.01%

1.4%

The following is a comparison of the 5-year performance of Home Depot, Lowe's and the S&P 500.

Source: Yahoo! Finance

This graph shows that over the long run, Home Depot has had the best performance. Lowe's outperformed in the past year, but this is a short-term trend. Moreover, Lowe's should be expected to outperform Home Depot, because it is riskier security overall. The underlying numbers in this graph show that according to the beta of Home Depot, that company should have increased around 85%, in line with its beta and the returns on the S&P 500. Home Depot actually returned nearly 250%, which is far better than would be expected given the risk level of the company. Home Depot has outperformed both the S&P and Lowe's on a raw and an risk-return basis. Lowe's should have generated a return around 120%, so it too outperformed the S&P 500 on a risk-adjusted basis, but it did not outperform Home Depot on a risk-adjusted basis.

Analysis and Conclusion

The different categories of ratios tell us different things about these two companies. The profitability ratios tell us how profitable the two companies are The gross margin reflects the bargaining power that the firm has over customers and suppliers. The gross margin is essentially the spread between what the firm pays its suppliers and what its customers pay it. The more bargaining power the company has the bigger this spread is going to be. Both companies have roughly the same bargaining power over their buyers and suppliers.

The operating ratio reflects the cost structure of each company. Home Depot has much better operating margin. This can be the result of greater efficiency that results from scale, but Home Depot also operates internationally, which creates a greater amount of overhead, negating some of the advantages of scale. Home Depot is simply a more efficient operation than is Lowe's. The net margin often flows from the operating margin, but can also reflect the ability of the firm to minimize its tax burden.. The spread between the operating and net margins is roughly equal with these two companies, giving the operational edge to Home Depot

The next set of metrics is the liquidity ratios. These ratios inform as to the short-term financial health of the company. In general, these are used to look for trends and for red flags. For example, Home Depot's current ratio is not much different than that of Lowe's. However, the quick ratio reflects the current ratio less inventories. Here, Home Depot has a much better ratio. This means that more of the current assets of Lowe's are in inventories. Home Depot, apparently, is moving its inventories out faster, replacing them with cash and with accounts receivable. The liquidity superiority continues with the cash ratio. For Lowe's the quick and cash ratios are still acceptable, but only borderline so. It would be preferable for the company to have better liquidity. There is the legitimate concern that compared with Home Depot, Lowe's has more inventory that is tougher to move. This will lead to discounts, which would reflect in a reduction in the gross margin next fiscal year, and it could also reflect eventually in writedowns.

The next set of metrics is the solvency ratios. These are used to analyze the long-term financial health of the company. These ratios are difficult to compare across industries because of different industry conditions, but are easy to compare with two companies as similar as Home Depot and Lowe's. There may be some differences with respect to firm preference, so there are fewer absolutes with the solvency ratios. Both firms in this case carry a very similar amount of debt on their respective balance sheets, so there is little to choose from with these ratios.

The final set of ratios consist of the investment return ratios. There are a number of different things to look at with respect to investment returns. The first is the total returns, which factor in dividends. For these two companies, there is little difference if their dividend policies, so capital gains alone are reasonable as a point of comparison between these two companies. Over the past year, Lowe's has delivered superior returns, but as the graph suggest Home Depot has the better returns over the long run. Both companies have outperformed the broad index, the S&P 500, but Home Depot is the better performer of the two.

It must be considered, however, that returns are relative to risk. Thus, Home Depot may return better because it is the riskier of the two companies. The common measure of risk is the beta. What we see here is that Home Depot has a beta of less than one, meaning that is has less risk than the general market. Lowe's has a beta of 1.22, which means that it is riskier than the general market. Thus, when Home Depot outperforms both Lowe's and the market, it is also doing so on a risk-adjusted basis because it has the lowest risk as well (the S&P risk is 1.00).

Two other considerations are the earnings and the forward price/earnings ratio. The earnings per share of Home Depot are $3.37 and for Lowe's they are $1.97, so there is a significant difference there. Interestingly, this means that there is quite a bit more left over for retained earnings at Home Depot, which has a long-run effect of greater capital gains. Yet, this is not priced into the stock. The forward price/earnings ratio for Home Depot is 18.3 and the forward price/earnings ratio for Lowe's is 19.6. This means that the market expects Lowe's to appreciate more in the short run than Home Depot. Granted, over the past year, Lowe's has outperformed. There may perhaps be the sentiment in the market that Home Depot's long run of success means that Lowe's will eventually have to catch up. This means that if the market believes that both companies will regress to the mean, Lowe's will see its stock price more quickly while Home Depot sees limited stock price progress. Such an assumption, however, would need to be predicated on the idea that both companies are roughly equal. This is not the case.

In terms of other qualitative factors, Home Depot also looks to be in better shape There are two different elements in particular where Home Depot is superior to Lowe's.… [END OF PREVIEW]

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