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.
In the case of Restoration Hardware Holdings Inc (NYSE:RH), it is growing at almost 40%; but what’s impressive is that Restoration Hardware is achieving all of its growth without expanding its stores. If Home Depot is 70% more expensive than Lowe’s Companies, Inc. (NYSE:LOW), and has top-line growth of 7.4%, then how much is Restoration Hardware Holdings Inc (NYSE:RH) worth with its growth? My answer is that it is worth significantly more than a 35% premium on The Home Depot, Inc. (NYSE:HD). The reason: It has more room to grow and is capitalizing on current market opportunities.
Next, everyone wants to look at the P/E ratio, and you see that Restoration Hardware is expensive according to its price times earnings. However, in the case of growth companies, the P/E ratio serves little meaning, as companies often spend money to grow. Therefore, top-line growth becomes the most important metric, which clearly shows Restoration Hardware Holdings Inc (NYSE:RH) as a company on the rise. Then, we can look at industry margins, which average 9% for Home Depot and Lowe’s, and assume that Restoration Hardware has a lot of space in front of it to improve margins.
Final Thoughts
When you consider the upside that Restoration Hardware Holdings Inc (NYSE:RH) has in the home improvement space, its value relative to growth, and the room for margin improvement, you can see why I consider it a value stock.
Sure, Restoration Hardware has seen post-IPO gains of 125%, trades at almost 40 times next year’s earnings, and contradicts what you think you know about value, but when compared to its industry, Restoration Hardware Holdings Inc (NYSE:RH) is cheap and has fundamental upside that far exceeds industry growth. These things combine to indicate that Restoration Hardware is in fact a value stock, one that you should explore.
The article Is This Momentum Stock Presenting Value? originally appeared on Fool.com and is written by Brian Nichols.
Brian Nichols is long RH. The Motley Fool recommends The Home Depot, Inc. (NYSE:HD) and Lowe’s Companies, Inc. (NYSE:LOW). Brian is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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