Saturday, September 20, 2008

Home Depot vs Lowe's: Return On Equity

Here's a look at the ROE of Home Depot and Lowe's over the last few years:

Considering all the negativity surrounding Home Depot, this has to come as a surprise to most. But looking at ROE alone does not tell the full story of how well a company is managed. If one company is too highly leveraged, then ROE can look good for a long period of time, before finally crashing down and leaving shareholders in the lurch (consider many US Banks and certain home builders).

So let's break down the ROE equation to determine what component debt is playing in boosting ROE, and what component approximates returns on invested capital.

ROE = Net Income / Equity = (Net Income / Assets) * (Assets / Equity)

(Net Income / Assets) is simply Return On Assets, which should give us a decent estimate of what kind of returns management gets on every dollar it invests in the business (e.g. land, buildings, inventory etc.). Here's the ROA of both Lowe's and Home Depot:

We see slightly better returns for Home Depot, which is consistent with what we saw when we analyzed the sales per square foot and profits per square foot of these two companies. Note that this measure is not a perfect one. It's possible that Home Depot has assets on its books that are understated as compared to Lowe's (e.g. land, which is stated at cost, even if it has appreciated in value).

And the second half of the equation above will show us how leveraged these two companies are:

We see that in the last couple of years, Home Depot has been further boosting its ROE by levering itself up. Is it too leveraged? The answer to this question is never clear. But one thing we do know is that recent quarters have not been kind to the housing market, and as a result, these two retailers have experienced declining business. Let's take a look at how well Home Depot has been able to cover it's interest payments in recent quarters during these rough times:

It would appear that throughout this downturn, they have had ample room to cover their fixed obligations, suggesting their debt load is at fairly safe levels.

Home Depot has been mired in negativity in the last few years. However, judging from these metrics, it would seem that they have run the business well. Of course, there have been some bumps in the road. As we saw here, many of the shareholder returns HD has generated were used to buy back stock at terrible prices. Going forward, however, HD seems to be in a position to provide shareholders with decent returns.

Disclosure: The author has a position in both HD and LOW


George said...

What's really important here is comparing returns on invested capital.

Saj Karsan said...

Hi George,

I agree that's an important measure, but it's not complete. Shareholders only own the equity portion, so if you only look at returns on invested capital, you ignore returns to shareholders, and don't properly assess whether management uses the right amount of debt.

mp said...

but less debt is better right? especially now

Saj Karsan said...

Hi Mark,

Less debt is certainly safer, but not necessarily better. As an example, a utility's operating profit may not fluctuate much even in a recession, and therefore it can use a decent amount of debt safely to finance it's operations, as this drives up returns for equity holders.

For this particular case, one would have to make an assessment of just how cyclical Home Depot is in order to determine the appropriate debt level. One way to judge is to look at their interest coverage ratios right now since these are bad times especially for this industry.