Does a Massive Share Buyback and a 34% Dividend Hike Make This Stock a Buy?

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In February Home Depot (NYSE: HD) announced its full years earnings, with revenue increasing 6.2% to $74.8 billion and earnings increasing 21.5% to $3 per share. Two other significant announcements were made on that day: a 34% increase in the quarterly dividend and a $17 billion share repurchase program expiring at the end of 2015.

A history of returning cash to shareholders

Since 2002 Home Depot has spent $37.5 billion in total on share repurchases, reducing the share count by roughly 1 billion shares. During the same period the company has increased its dividend at an annualized rate of about 20%, growing from $0.21 annually in 2002 to a projected annual payment of $1.56 in 2013.

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HD Average Diluted Shrs Outs Annual data by YCharts

The 34% dividend increase puts the current dividend yield at 2.23%, just slightly above the dividend yield of the S&P 500.

Are these buybacks a good idea?

Share buybacks are a good use of cash only if a company's shares are undervalued. If a company buys back shares that are overpriced then this money is essentially being wasted. Home Depot's plan to spend $17 billion over the next 3 years on buybacks is an increase in pace over the past decade, but is it reasonable? Here's a chart of the TTM P/E ratio since 2002.

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HD PE Ratio TTM data by YCharts

Home Depot stock is more expensive than it's been in the last ten years. Even during 2006 and 2007, when the company saw rapid revenue growth to $90 billion per year, the stock was trading with the P/E ratio below 15. Based on the above chart of outstanding shares this is the time period in which a large portion of the buybacks occurred. Now, with a P/E ratio of about 23, the company will be paying a much higher price for its own shares.

The buyback will boost EPS, but with the P/E ratio at an elevated level I don't expect any real benefit from this program. The company has guided for sales growth of 2% in 2013 and EPS growth, including the effect of the buyback program, of 12%. Paying 23 times earnings for 12% growth after being goosed by the buybacks seems pretty expensive to me. Without the effect of buybacks EPS growth would be more like 8%, making the picture look even worse. Hopefully the company picks its moments and only buys shares when the price gets depressed, but I doubt this will happen. All this money for the buybacks would be better spent on increasing the dividend.

Fast growth, low yield

With Home Depot's dividend yield sitting at 2.23% the dividend needs to grow quickly in the future in order to justify an investment. The company has stated that it aims to have a payout ratio of 50%, and with the new increased dividend the payout ratio using 2012 net income is just a hair above this 50% mark. Measured relative to the free cash flow the payout ratio is a lower 41%. Over the past decade the dividend grew at 20% annually, but this was driven largely by an expansion of the payout ratio. Since 2003 EPS has only grown at an annualized rate of 5.3%, so indeed most of the dividend growth was a result of upping the payout ratio. Now that the 50% target has been reached future dividend growth will only be as fast as earnings growth. And even with the effect of the buybacks this is only expected to be 12% next year.

How fast does the dividend need to grow to justify an investment? We can do a simple dividend discount calculation to find out. The total dividend in 2012 was $1.16 per share, and we know that 2013 will see a 34% dividend increase. Over the ten years after that, how fast does the dividend need to grow?

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About 13.6% annually. Is this possible? The average analyst estimate for 5-year annual earnings growth is 14.51%, so this number is certainly within the realm of possibility. But remember that there isn't really any room for an expansion of the payout ratio, so the 20% growth of the past is not going to repeat itself.

What about Lowe's?

Home Depot competitor Lowe's (NYSE: LOW) saw its annual revenue climb only 0.62% in 2012, and its Q4 revenue actually declined by 5% year-on-year. Lowe's pays a lower dividend that Home Depot, only a 1.66% yield, but with a payout ratio of just 36.7% there is ample room for expansion. Lowe's trades at a similar P/E ratio of 22.7, but EPS has been boosted over the past two years by large share buybacks. Net income has actually shrunk since 2010, which is not the case for Home Depot. It seems that Lowe's is relying far more heavily on buybacks to boost its bottom line than Home Depot, and without the buybacks EPS actually would have declined since 2010. With similar P/E ratios, Home Depot is the clear choice between the two.

The bottom line

Home Depot's massive share buyback program comes at a time of a historically high valuation, leading me to believe that the effect of the program will not be positive for the company. It seems like an attempt to artificially boost the EPS, but even with the buyback growth will be too slow to justify a P/E ratio of 23. The dividend will certainly grow at a much slower pace than it did over the past decade, and with a yield of just 2.23% there are far better choices out there in terms of dividend stocks. Although a better choice than Lowe's it looks to me that Home Depot's stock has risen too far too fast, and I would wait for a substantial decline before considering buying shares.

Timothy Green has no position in any stocks mentioned. 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!

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