Option on HomeDepot
In my last article, I wrote that at $37, Home Depot is undervalued even if you assume no earnings growth. Currently, Home Depot trades at 12 times this years earnings, and its earnings have grown over 15% the post couple of years. If it were possible for Home Depot to grow earnings that much over the next 5 years, then it would easily deserve a P/E multiple of 20. However, this won’t be possible.
First, it’s hard to grow when your revenues approach $100 billion a year. There do-it-yourself outlets are so saturated that new stores are “canabalizing” older stores. So, as I mentioned before, the growth will either have to come from Home Depot supply or from international growth.
Second, the housing market is cyclical. Even though I don’t think the effect of the housing downturn will be as much as most people fear, it will still have an impact on growth. Since, the housing market was strong the last couple of years, the growth of over 15% is somewhat of an abnormality.
Now, I have no idea what the future growth will be, but I think it will be somewhere between 0 and 15%+. So, it has to trade with a P/E between 12 and 20. Conservatively, I think it should trade at 15 times earnings or $45 dollars. If this analysis is correct, an investor would make 20% on their investment.
Although, a 20% return is pretty good. There is another way to increase return with the use of options if you are sure about the performance of HD stock.
The easiest and safest strategy is to write a spread. For example, I sold a Jan 2009 $45 call and I bought a Jan 2009 $35 call at a net price of $3.50. If HD is $45 on Jan 2009, I will be able to sell it for $10 and make a 200% return. If at anytime, the stock goes up, the net price will rise. I bought 22 of these options for a net price of $3.50 or $7,700. The price is around $4.30 now. So that gives me over a 20%+ return. I bought it when HD was trading a little over $34. Of course, If HD stays below $35 on Jan 2009, I will lose all my money. :-)
Another options strategy is to buy a Jan 2009 call and sell a Jan 2009 put (synthetic buy). The net price should be somewhere in the $4 range at the current price. It essentially allows you to buy a share of HD. Obviously the returns are much nicer if HD goes up. This strategy is a little bit riskier because you could lose $39 if HD goes to 0. However, the upside is unlimited and better than the aforementioned options strategy.
If all of this is too confusing, you should just buy shares of HD. However, I feel options are the way to go with HD because of the fact that the shares have little downside.
First, it’s hard to grow when your revenues approach $100 billion a year. There do-it-yourself outlets are so saturated that new stores are “canabalizing” older stores. So, as I mentioned before, the growth will either have to come from Home Depot supply or from international growth.
Second, the housing market is cyclical. Even though I don’t think the effect of the housing downturn will be as much as most people fear, it will still have an impact on growth. Since, the housing market was strong the last couple of years, the growth of over 15% is somewhat of an abnormality.
Now, I have no idea what the future growth will be, but I think it will be somewhere between 0 and 15%+. So, it has to trade with a P/E between 12 and 20. Conservatively, I think it should trade at 15 times earnings or $45 dollars. If this analysis is correct, an investor would make 20% on their investment.
Although, a 20% return is pretty good. There is another way to increase return with the use of options if you are sure about the performance of HD stock.
The easiest and safest strategy is to write a spread. For example, I sold a Jan 2009 $45 call and I bought a Jan 2009 $35 call at a net price of $3.50. If HD is $45 on Jan 2009, I will be able to sell it for $10 and make a 200% return. If at anytime, the stock goes up, the net price will rise. I bought 22 of these options for a net price of $3.50 or $7,700. The price is around $4.30 now. So that gives me over a 20%+ return. I bought it when HD was trading a little over $34. Of course, If HD stays below $35 on Jan 2009, I will lose all my money. :-)
Another options strategy is to buy a Jan 2009 call and sell a Jan 2009 put (synthetic buy). The net price should be somewhere in the $4 range at the current price. It essentially allows you to buy a share of HD. Obviously the returns are much nicer if HD goes up. This strategy is a little bit riskier because you could lose $39 if HD goes to 0. However, the upside is unlimited and better than the aforementioned options strategy.
If all of this is too confusing, you should just buy shares of HD. However, I feel options are the way to go with HD because of the fact that the shares have little downside.
posted by Amit Dhuleshia at 7:22 PM
1 Comments:
Hi Amit,
I think the strategy of a vertical bull spread is a pretty good one and your analysis was very insightful. Given HD's current price point I think the odds of this strategy working out are pretty good.
Aravind
BTW: you can check my blog at
http://aravindsuri.blogspot.com
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