How Tax Cuts Could Boost Home Depot's Stock

(Note: The author of this fundamental analysis is a financial writer and portfolio manager.)

Home Depot Inc. (HD) shares have risen by nearly 33 percent in 2017, outpacing the S&P 500 Index, and its biggest rival, Lowe's Corp. (LOW).

Home Depot stock has gained almost 12.5 percent since September 1. Part of the reason for the increase is that the sector has come to life. The Consumer Discretionary Select Sector SPDR (XLY) has risen by nearly 7.5 percent.

Another reason for the boost in Home Depot's stock is that investors are anticipating the potential savings the company will see should there be a corporate tax cut, which will boost earnings. 

Based on the latest analysis, it looks like Washington's tax reforms could reduce Home Depot's effective tax rate from 37 percent, as of the latest quarter, to around 23 percent. To get the lower 23 percent tax rate, we added 3 percent state and local taxes to the proposed 20 percent rate.

That tax cut would have boosted Home Depot's third-quarter net income by $500 million, or 22 percent, or about $2 billion annually. That's no small chunk of change. Tax reforms' similar impact on 2018 and 2019 earnings growth could sharply bolster Home Depot's stock. 

HD Effective Tax Rate (Quarterly) data by YCharts

Multiple Expansion

So while Home Depot shares climb, it is for a good reason and is helping fuel multiple expansion. Over the past two years, Home Depot hasn't seen its one-year forward earnings estimate multiple trade at a level much over 19, but now shares are trading at a lofty 21 times. That's not expensive compared to the S&P 500, which is trading at roughly 19 times. 

HD PE Ratio (Forward 1y) data by YCharts

Lower Tax Rate

The reason for the multiple expansion is because investors are anticipating a lower corporate tax rate. Lower corporate taxes will fuel higher earnings, and that will reduce Home Depot's earnings multiples in time.

Home Depot paid nearly $1.27 billion in taxes in its latest quarter, and a lower tax rate will immediately boost net income, and therefore earnings per share. 

HD Pre-Tax Income (Quarterly) data by YCharts

Tax Savings

Should Home Depot's effective tax rate drop to 23 percent, making provisions for any state and local taxes, its tax provisions for the previous quarter would have fallen to about $790 million. That's a decline of nearly 38 percent, and it would have boosted net income by nearly 22 percent to $2.65 billion.

When reviewing Home Depot's earning projections, it's unclear whether analysts have priced in a corporate tax cut. Therefore, using the company's latest quarterly results gives a better assessment of the potential benefit the company could see. 

It is likely Home Depot will be a big beneficiary of corporate tax reform, and that is the reason for the recent rise in the company's stock price. It's also likely that Home Depot shares will continue to rise as the added tax benefit gets priced in. (See also: Home Depot Poised to Rise 11% on Tech Strategy.)

Michael Kramer is the Founder of Mott Capital Management LLC, a registered investment adviser, and the manager of the company's actively managed, long-only Thematic Growth Portfolio. Kramer typically buys and holds stocks for a duration of three to five years. Click here for Kramer's bio and his portfolio's holdings. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future performance.