Home Depot Case Study

Final Project: Home Depot Case Study

Matthew Prescia

The time value of money is “the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity” (“Time Value of Money”, n.d.).  When looking at a company’s potential, it is a good idea to find the present value, and calculate the present value using the Discounted Cash Flows Model.  This model is used to “estimate the attractiveness of an investment opportunity” (“Discounted Cash Flow”, n.d.).  By looking at Home Depot’s financial statements within their annual report, it can be determined the present value of the company using free cash flows.  

        By looking at the Balance Sheet and Income Statement of Home Depot, it is possible to calculate the free cash flows, which can then be used to find the present value.  The free cash flow formula is net operating profit after taxes (NOPAT) – net investment in operating capital (Ehrhardt & Brigham, 2012).  This can be broken down to NOPAT – the change of total operating capital from the previous year.   In my calculation I used the tax rate of 35% and the Interest Rate (Weighted Average Cost of Capital) of 9%.  By using these rates, I came up with a present value of $7,115.46 for year 1, $4,916.96 for year 2, $5,877.44 for year 3, $4,615.04 for year 4, and $4,445.68 for year 5.  This comes to a total present value of $26,970.58 (which is represented in millions).  I assumed a sales increase of 5% for each year, and proportionally increased cash, accounts receivable, inventories, property plant and equipment, accounts payable, accruals, taxes payable, and deferred revenue to sales for the forecasted years 2016 through 2019.  

        If the risk of the company changes based on an internal event, the present value will change as well.  If the discount rate, or WACC increases, this means that the risk associated with the company is higher.  On the contrary, if the WACC decreases, than the risk associated with the company is lower.  With a higher risk, the present value of the company will decrease.  This simply means that with a higher risk (increased WACC), you would have to put less money away today to achieve and earn a certain amount in the future.  One of the risks that Home Depot’s annual report lists as a potential risk is “our success depends upon our ability to attract, train, and retain highly qualified associates while also controlling our labor costs.”  With that being said, if Home Depot fails to continue to do successfully attract, train and retain qualified associates, the risk factor will change due to dissatisfied employees which can ultimately lead to customers not being happy, which results in losses.  So suppose Home Depot fails to attract, train, and retain qualified associates, and the risk increases to 11 percent.  This would change the present value of the company.  On the Home Depot Case Study spreadsheet, I recalculated the present value with this updated WACC.  Although the Free Cash Flow amounts remained the same, the total present value of Home Depot decreased from $26,970.58 to $25,644.70, a 4.92 percent decrease.  

        Finding the value of a company using free cash flows is important when a buyer is interested in purchasing a company.  With the calculations I have provided on the Home Depot Case Study, a reasonable amount that Home Depot should be sold for is less than $26,970,580,000.  This is because although the present value is listed at that amount, “small changes in inputs (such as free cash flow forecasts, discount rates and perpetuity growth rates) can result in large changes in the value of a company” (Wilkinson, 2013).  In result, Wilkinson states that if value arrived of the Discounted Cash Flow analysis is higher than the current cost of the investment, the opportunity may be a good one.  

        With change in risk, as stated before, the present value will change.  If the risk increases, the value will decrease, and if the risk decreases, the value will increase.  If an event occurs that increases the risk, the company’s value will decrease, which in result will have investors wanting a higher rate of return since there is more risk involved with their investment.  As a company, if the risk increases, the managers and CFO will want to respond to the event quickly so they can reverse the negative result of the increased risk.  On the other hand, if the company’s risk decreases, the value of the company increases and investors will not get as high of a return since there is no risk (generally speaking, higher the risk, higher the reward).  

        When deciding whether or not to purchase a company, the future value of the company is a good basis of what the price you should be willing to pay.  Although this is a good starting point to the decision, the free cash flows in the future years are estimated.  With this being said, the risk can change, for better or worse.  The formula for the future value is FV=PV* (1+i)^n.  So in with Home Depot, fv= 26,970,580 * (1+.09) ^5.  The value I have calculated in the Home Depot spreadsheet is $41,497,580.47.  The price that Home Depot should be sold for is less than that amount, because if the risk increases, the value decreases, so it would not be smart to assume that the risk will stay the same, or lower (which would increase the value).  

        Finding the present value of a company is very beneficial when it comes time to make decisions of whether or not to buy a company.  In this Home Depot Case Study, I used the free cash flows for 2015, and then assumed an increase in sales, and made predictions of the next four years.  This is a very good financial analysis tool because you can determine what the company is worth, and how much money should be paid in order to buy the company.  Change of risk can drastically change the value of the company, and risk can change from either internal or external events.  This has to be thought about when coming up with the present value of the company, and it would be naïve to believe that the risk of the company will remain constant.  

        Stock valuation and bond issuance analysis is a critical component of capital markets.  Capital markets are “markets for buying and selling equity and debt instruments” (“Capital Markets,” n.d.).  Investopedia goes on to say that equity securities are known as stocks, and debt securities are known as bonds.  Selling stock and issuing bonds are great ways to gain more capital.  With issuing stocks, companies need to determine if they have earned enough profit in order to pay its stockholders dividends.  “Dividends can look favorable to investors…a high quality dividend growth stock will compound investor wealth for years – if not decades” (10 Critical tips for Dividend, 2015).  With that being said, having a dividend policy could potentially increase the amount of shareholders due to its returns to the investors.  Issuing bonds helps companies finance operations (Renaud, n.d.).  Although companies can borrow money from banks, most companies find borrowing from a bank restrictive and more expensive than issuing bonds.