Value Explained!
There is a belief among retail investors that in order for a stock to be considered a value investment it must meet generalized criteria, those that you could identify on a stock screener. One of the most popular metrics among retail investors is the P/E ratio, which compares a company’s market capitalization to its net income. While I have heard many “rules” regarding a P/E ratio, most retail value investors would like to think that a stock trading over 20 times earnings could not possibly present value – or could it?
In my book “Taking Charge With Value Investing (McGraw-Hill, 2013)” I worked very hard to attack many of these psychological notions of value. Based on my research, most of these myths of value are determined by investors who believe that there is an actual formula for value investing that they can adhere to and be successful.
In my book, I explain that generalizing a P/E ratio, price/sales ratio, or a price/book ratio are all worthless in a widespread setting. Instead, I suggest breaking away from these notions, and relying more on a stock’s comparison to its peers as an indication of value. This strategy is what leads me to my conclusion that regardless of stock performance, a stock can still present value, much like Restoration Hardware.
Compare To Find Value
In an attempt to determine whether a stock is presenting value, we need to compare it to its peers, not the overall market. Thus, let’s see how Restoration Hardware Holdings Inc (NYSE:RH) compares to its larger peers.
| Restoration Hardware | The Home Depot, Inc. (NYSE:HD) | Lowe’s Companies, Inc. (NYSE:LOW) | |
|---|---|---|---|
| Market Cap (billions) | $2.7 | $117.3 | $47.3 |
| Price/Sales | 2.09 | 1.55 | 0.93 |
| Revenue Growth (last quarter) | 38.3% | 7.4% | (0.5%) |
| Forward P/E Ratio | 37 | 18.85 | 17.43 |
| Operating Margin | 3.87% | 10.89% | 7.29% |
The first thing to notice is that Restoration Hardware Holdings Inc (NYSE:RH) is at a different stage in its business versus The Home Depot, Inc. (NYSE:HD) and Lowe’s Companies, Inc. (NYSE:LOW). Restoration Hardware is a growth company, while Home Depot and Lowe’s are more cyclical in nature. This alone changes the typical valuing metrics, as growth companies are awarded larger valuations versus those that replicate GDP in growth.
Nonetheless, The Home Depot, Inc. (NYSE:HD) and Lowe’s Companies, Inc. (NYSE:LOW) set the standard for valuing such companies in the space, and both trade with metrics that are greater than the S&P 500. With that said, Lowe’s and Home Depot have $125 billion in combined revenue; Restoration Hardware Holdings Inc (NYSE:RH) has revenue of just $1.3 billion; this leaves a significant amount of room to grow for Restoration Hardware.
The next metric to look at is price/sales, and its relevance to growth. First, The Home Depot, Inc. (NYSE:HD) is more expensive than Lowe’s Companies, Inc. (NYSE:LOW). However, Home Depot is also producing top-line growth, while Lowe’s is not. Therefore, The Home Depot, Inc. (NYSE:HD) trades at a premium to Lowe’s.
