Is This Momentum Stock Presenting Value?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In my article, “Top Value Stocks for the Next Six Months,” I included Restoration Hardware (NYSE: RH) as a top “value” pick. Immediately, I received several comments, explaining that I should revisit the rules of value investing, and that Restoration Hardware at 37 times next year’s earnings could not possibly be a value investment – or is it?

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 compares to its larger peers.

<table> <thead> <tr><th> </th><th> <p>Restoration Hardware</p> </th><th> <p><strong>Home Depot</strong> <span class="ticker" data-id="203819">(NYSE: <a href="">HD</a>)</span></p> </th><th> <p><strong>Lowe’s</strong> <span class="ticker" data-id="204349">(NYSE: <a href="">LOW</a>)</span></p> </th></tr> </thead> <tbody> <tr> <td> <p>Market Cap (billions)</p> </td> <td> <p>$2.7</p> </td> <td> <p>$117.3</p> </td> <td> <p>$47.3</p> </td> </tr> <tr> <td> <p>Price/Sales</p> </td> <td> <p>2.09</p> </td> <td> <p>1.55</p> </td> <td> <p>0.93</p> </td> </tr> <tr> <td> <p>Revenue Growth (last quarter)</p> </td> <td> <p>38.3%</p> </td> <td> <p>7.4%</p> </td> <td> <p>(0.5%)</p> </td> </tr> <tr> <td> <p>Forward P/E Ratio</p> </td> <td> <p>37</p> </td> <td> <p>18.85</p> </td> <td> <p>17.43</p> </td> </tr> <tr> <td> <p>Operating Margin</p> </td> <td> <p>3.87%</p> </td> <td> <p>10.89%</p> </td> <td> <p>7.29%</p> </td> </tr> </tbody> </table>

The first thing to notice is that Restoration Hardware is at a different stage in its business versus Home Depot and Lowes. 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, Home Depot and Lowe’s 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 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, Home Depot is more expensive than Lowe’s. However, Home Depot is also producing top-line growth, while Lowe’s is not. Therefore, Home Depot trades at a premium to Lowe’s.

In the case of Restoration Hardware, 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, and has top-line growth of 7.4%, then how much is Restoration Hardware worth with its growth? My answer is that it is worth significantly more than a 35% premium on Home Depot. 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 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 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 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.

Brian Nichols is long RH. The Motley Fool recommends Home Depot and Lowe's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus