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Valuation and Analysis of Home Depot Inc.

Gracie Quintana Jeff Miller Christine Kyrish Steven Poon

December 6, 2004

Table of Contents

Financial Data Snapshot I. Overview of Valuation II. Business Summary Products and Services Competitors Industry Analysis Competitive Strategy III. Accounting Analysis Accounting Policies Degree of Accounting Flexibility Accounting Strategy Quality of Disclosure Quantitative Analysis Red Flags IV. Ratio Analysis and Forecasts Ratio Analysis Section Financial Statement Forecasting Methodology Conclusion V. Valuation Cost of Capital Method of Comparables

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Discounted Dividends Discounted Free Cash Flows Discounted Residual Income Long Run Average Residual Income Abnormal Earnings Growth Altmans Z-score Results VI. Analyst Recommendation VII. References VIII. Appendix Industry Graphs Ratio Analysis Competitor Annual Financials Quarterly Financials and Forecasts Annual Financials and Forecasts Calculations used in Valuations Method of Comparables Valuation Discounted Free Cash Flow and Sensitivity Analysis Valuation Discounted Dividends and Sensitivity Analysis Valuation Residual Income and Sensitivity Analysis Valuation Abnormal Earnings Growth and Sensitivity Analysis Valuation

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Investment recommendation: Home Depot is slightly overvalued therefore we recommend it as a hold. The stock is poised to perform at least as well as the market.

Home Depot is expected to penetrate foreign markets; this growth opportunity will increase market share and the bottom line. Uncertainty in the economy affects Home Depots sales, as it operates in a cyclical industry. This uncertainty will not have a detrimental impact on the long term growth of Home Depot and its subsidiaries.

I. Overview of Valuation Company and Industry Overview The Home Depot, Inc. is the worlds largest home improvement retailer and the second largest retailer in the United States, earning $64.8 billion in revenues during the 2003 fiscal year. Operating under the cost leader strategy Home Depot derives its key

success factors based on a tight-cost control system, stability of sourcing channels, and a growth strategy based on core competencies. Home Depots growth strategy permits further market penetration by enhancing a value chain of lower priced premium products and the expansion of new store formats to support growing market trends. The successful integration of distribution centers that lower transaction costs, an expansive product selection through exclusive and proprietary agreements, and the initiation of a quality assurance program positioned Home Depot to earn consistent above-average profits within a highly fragmented retail (home improvement) industry. Accounting Analysis The accounting policies adopted by the Home Depot prove to be in line with its business strategy. Overall, the Home Depot is very forthcoming with their accounting practices and policies. The specifically identify three major areas of accounting policy in regards to their specific industry to further their business strategy as it relates to merchandise inventories, self insurance and revenue recognition. The firm is proactive in divulging accounting policy regarding each of these areas. They specifically address the firms actions in regards to required GAAP changes and liberally discuss their adoption of certain GAAP in their financial reporting such as their policy regarding the upcoming change in policy for the firm in their treatment of operational leases as opposed to capital leases. The firm goes as far as to forecast how the change in policy will affect future financial statements in 2004 the notes to their 2003 financial documents. Ratio Analysis Computation of the ratios relevant to the home improvement retail industry shows no significant problems for Home Depot. Home Depot is operating on relatively wide margins compared to its competitors. Costs have been managed well and debts are being

paid more slowly; this does not pose a problem because the average payment time for the industry is much slower than Home Depot. The sustainable growth rate is quite high compared to Lowes which can be explained by Home Depots innovative business strategy. Forecasting Sales growth over the past five years has grown fairly consistently. The growth rate in sales is assumed to continue into the future, with a similar upward trend in future earnings. Recently, Home Depot has taken on more short term debt, but this should not impact their capital structure significantly. Total assets have been steadily increased over the past five years and that trend is expected to continue. There is not a large spread between the operating cash flow and earnings, which is a good sign for the quality of accounting information. The growth trend in assets and income and cash flow can be expected to increase because of expansion into other countries, mainly China and Mexico. Valuation Different methods of valuation were used to assess the value of Home Depot. We have the most faith in the abnormal earnings growth, residual income, and discounted cash flow valuation methods. In the abnormal earnings and residual income model, the stock was overvalued. In the discounted cash flow method the stock was slightly undervalued. In the method of comparables valuations, the stock was most accurately priced by the P/E method. If modest growth rates are assumed, along with a beta slightly above the markets beta, Home Depots stock is slightly overvalued.

II. Business Summary The Home Depot, Inc. is the worlds largest home improvement retailer and the second largest retailer in the United States. Home Depot distinguishes itself as the leader of the retail (home improvement) industry by focusing on sales, service, and execution. By utilizing this operating strategy Home Depot reported a sales growth of 11.3% during the 2003 fiscal year earning $64.8 billion in revenues, up from $58.2 billion in 2002. The Home Depot, Inc. has set itself apart from industry competitors by implementing a growth strategy of strengthening its core competencies by offering every customer a unique experience through store modernization, carrying a variety of distinctive merchandise, providing high quality service associates, and expert information technology. Subsidiaries of Home Depot, Inc. provide specialized services to both the individual homeowner as well as the professional customer. Home Depot has a competitive advantage over other firms in the industry by creating a dimension of tight cost control and providing premium value to customers through merchandise selection and expert service. Home Depot is currently operating 1,778 stores in the United States, Canada, and Mexico. The Home Depot, Inc. is in a highly competitive industry that is based on the factors of price, store location, customer service, and depth of merchandise. Home Depot estimates that its share of the U.S. home improvement industry is approximately 11 percent. Globally the home improvement industry is approximately at $900 billion offering extraordinary growth opportunities. The Company experienced an increase in comparable store sales of 3.8% in fiscal 2003 with an average ticket of $51.15, the highest in company history. The lawn and garden category was the biggest driver in fiscal 2003 for the boost in store sales. This increase in comparable lawn and garden sales can be tied to firm rivalry in the Southern United 7

States, between Home Depot and Lowes, where a growing customer base and loyalty is being won or lost as patrons have been affected by three hurricanes within thirty days of each other. Products and Services Home Depot provides a blend of high-quality merchandise for all areas of home improvement. In a highly competitive market Home Depot relies on competitive pricing strategies, service-oriented associates, and supplying a combination of higher-end premium products at a fair value. The Home Depot, Inc. provides specialized services to the customer market through two main types of stores, Home Depot Stores and EXPO Design Center Stores. Home Depot Stores sell a wide range of building materials for home improvement, lawn and garden products, and provide a number of valuable services. HD expanded a number of in-store initiatives and programs to increase customer loyalty including: Professional Business Customer Initiative: The Company increased the available quantities of products typically purchased by professionals in bulk to provide additional savings to the customer. HD has successfully anchored a position as a cost leader through this initiative of a tight cost control system and low-cost distribution. Color Solutions Center: HD provides leading paint brands and proprietary paint matching technology. Appliance Sales: HD provides customers with unique premium appliances manufactured by General Electric, Maytag, and other leading manufactures as well as displaying and stocking the more popular appliances in the store. Designplace Initiative: Offering an enhanced shopping experience to design customers HD highlights its core competencies with superior product variety and customer service. HD provides personalized service, specially-trained associates, and an expansive merchandise selection.

Tool Rental Centers: HD rents approximately 225 commercial-quality tools in 12 categories, including saws, floor sanders, generators, gas powered lawn equipment, and plumbing tools to satisfy a broad range of the needs of professional and do it yourself customers. This initiative allows HD to operate under a tight cost control system and emphasize a key success factor of high quality merchandise.

EXPO Design Center Stores offer interior design products, such as kitchen and bathroom cabinetry, soft and hard flooring, appliances, window treatments, lighting fixtures, and arrange installation services through qualified independent contractors. The EXPO Design Center Store focuses on distinguishing itself from other industry competitors by providing a strong value chain network of premium products and accentuating core competencies within the business segment. Competitors With few direct competitors found within the highly fragmented home improvement industry, Home Depot has differentiated its stores by offering several unique formats to accommodate the needs and interests of customers while offering products at a cost lower than the premium price customers are willing to pay. Of the 1,788 stores The Home Depot, Inc. was operating at the end of the second-quarter of fiscal 2004 1,569 are Home Depot stores, 54 are Expo Design Centers, 11 Home Depot Landscape Supply SM, 5 Home Depot Supply SM, and 2 Home Depot Floor Stores. For this reason The Home Depot, Inc. has pitted itself against competition outside of its immediate industry, retail (home improvement), and increased the high threat of substitute products.

Lowes Companies, Inc. (LOW) is the second largest retailer of home improvement products in the world with $33.9 billion in revenue for the 2003 fiscal year. With low switching costs to customers Lowes is Home Depots main rival within the industry. Lowes serves and specializes in the do-it-yourself (DIY) customers, appliances, lawn and garden, home dcor, repair/remodeling, specialty trade contractor, and property management market segments of the home improvement industry. Lowes, as of January 31, 2003, operated 854 stores in 44 states with approximately 94.7 million square feet of retail selling space. The company is operating under an aggressive growth strategy focusing much of its future expansion on metro-markets with populations of 500,000 or more. Lowes home improvement warehouse carries over 40,000 products and each store provides a wide selection of nationally advertised brand name merchandise. Of the thousands of items offered, both in the store and available through its special orders system, Lowes merchandise selection supplies both the do-it-yourself (DIY) customer and the commercial business customer with products and merchandise needed to repair, maintenance, and complete construction projects. Lowes sources its products through 7,000 vendors worldwide, with no single vendor accounting for more than 4% of the total purchases. The company is not dependent on a single vendor and has alternative competitive distribution access available from suppliers to further increase its opportunities for product quality and gross margin. The company has a strategic alliance with HGTV network that allows it to exclusively run commercials for a substantial portion of the commercial airtime. This is only one of a half dozen media partnership programs employed to build the image and equity of the Lowes brand.

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Sherwin-Williams Company (SHW) generated $5.4 billion in revenue for the fiscal year ending December 31, 2003 by engaging in the manufacturing, distribution, and sale of coatings and related products to professional, industrial, commercial and retail customers primarily in North and South America. The company relies heavily on trademarks and trade name recognition, which significantly supplement the sales. The Paint Stores Segment manufactures original equipment manufacturer (OEM) product finishes. Original equipment manufacturer product finishes are sold to certain shared or dedicated paint stores and by direct outside sales representatives building strong and exclusive relationships with both buyers and suppliers of paint. The company is a leading manufacturer and retailer of paints, coatings and related products to professional, industrial, commercial and retail customers. Sherwin-Williams has a competitive advantage over EXPO Design Centers by sustaining their industry position as the leading manufacturer and retailer of paints. The sustainability of competitive advantage is volatile depending on both product offered and market. Tractor Supply Company (TSCO) is focused on supplying products for the lifestyle needs of the recreational farmers and ranchers as well as tradesmen and small businesses. The Company has identified a specialized market niche and focuses its product mix on these core customers. The Company utilizes an everyday low price strategy and offers exclusive top quality private label products to sustain a strategic advantage over general merchandise, home center, and other specialty stores. Tractor Supply Co. created a uniform store layout to provide maximum sales and operating efficiencies. The company believes that is has differentiated itself by from big box retailers by focusing on the specific needs of a target customer base. By utilizing this

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strategy TSCO has strengthened its value chain in comparison to Home Depots lawn and garden segment. Building Materials Holding Corporation (BHMC) is one of the largest residential construction service companies in the United States with sales in excess of $1 billion. The Company specializes in providing construction services, manufactured building components, and high quality materials to residential builders and contractors. By targeting professional builders and contractors BHMC has positioned itself to gain high-volume repeat customers. Building Materials Holding Corp. operates by concentrating on manufacturing and installation services, on-time job-site delivery, and volume purchasing which are not typically offered at smaller consumer-oriented retailers but will become important to sustain a competitive advantage as the baby boomer generation moves into the do-it-for-me (DIFM) segment of the market. Griffin Land & Nurseries Incorporated (GRIF) is operated by its wholly owned subsidiary, Imperial Nurseries, Inc. The landscape nursery business is extremely fragmented, and the Company believes that its sales volume places it among the 20 largest landscape nursery growers in the industry. Imperial is currently reviewing a number of ways to increase return on assets for its growing operations such as an increase in the percentage of its product sold to retail garden centers. Sales to garden centers generally have more favorable gross margins than those from sales of mass merchandisers. The Companys growing operations have been effected by seasonality and increased shipping costs through distribution channels. Industry Analysis The retail (home improvement) industry is highly fragmented and has few direct competitors for The Home Depot Inc. The Home Depot, Inc. and Lowes Companies, 12

Inc. dominate the industry, controlling more than 30% of the U.S. market; Lowes, to date, remains Home Depots single direct competitor within the industry. Home Depot, Inc. has several store formats to compete in this highly fragmented industry, the store formats include the traditional Home Depot store, EXPO Design Center store, The Home Depot Supply store, Home Depot Landscape Supply, and The Home Depot Floor Store. The estimated market share holding for Home Depot in the home improvement industry is 11% at end of fiscal year 2003 but because of the fragmented industry measuring the effect of sales against competitors is extremely difficult. The Five Forces Model associates the intensity of competition and determines the potential for creating abnormal profits by the firms within the industry. Rivalry Among Existing Firms The retail (home improvement) industry has an extraordinary opportunity for growth globally. Viewed as once a stagnant market Home Depot has estimated the global home improvement industry to be approximately $900 billion with enormous potential for abnormal profits. Home Depot, Inc. is capitalizing on this by operating 102 Home Depot stores in eight Canadian provinces and 18 Home Depot stores in Mexico. To increase customer base and service levels Home Depot often opens new stores near the edge of market areas currently served by existing stores. This operating strategy, known as cannibalization, initially has a negative impact on store sales but provides for long-run profitability by increasing customer service levels, gaining incremental sales, and enhancing long-term market penetration. The retail (home improvement) industry is highly concentrated with few publicly traded direct competitors. Home Depot defines itself through an operating strategy based on core competencies, premium merchandise, and lower costs. 13

Threat of New Entrants The Home Depot, Inc. offers product category leadership by offering high-end appliances through exclusive agreements with manufacturers, superior quality service by providing free how-to clinics, kiosks enabling customers to identify projects and print step-by-step instructions in the store, and remains a cost leader through tight cost control by offering tool rental centers to customers which offer 225 commercial-quality tool in 12 categories. Most of the premium merchandise offered in Home Depot is purchased directly through the manufacturer. Home Depot has formed strategic alliances and exclusive relationships with a number of suppliers to market products giving Home Depot an absolute cost advantage over new entrants. Home depot is dependent upon the timely execution and delivery of products to its stores to maintain an inventory of competitively priced premium products. To compete nationally Home Depot has built central distribution centers to process globally sourced merchandise more efficiently. Transit facilities have effectively lowered the number of distribution centers required in the United States and Canada. Home Depot utilizes 10 transit facilities in the United States. It is here that Home Depot receives and processes merchandise from manufacturers and then immediately cross-docks it onto trucks for delivery to specific stores. Approximately 40% of the merchandise shipped to the stores was processed through the network of distribution centers and transit facilities with the intent of lowering distribution costs and increasing seamless efficiencies for the end-consumer. Threat of Substitute Products Customers willingness to switch is often the critical factor in making the competitive dynamic work. Home Depot maintains a global merchandise program to

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source high-quality products directly from overseas manufacturers, which gives the customers an expansive selection of innovative products and better value, while enhancing gross margin. Outside, smaller, retailers have the ability to target a specific need and interest of the consumer and to provide dedicated service and knowledge to an individual customer. Strategic alliances from manufacturers for exclusive product distribution in dedicated home improvement stores, such as Sherwin-Williams with Dutch Boy paint, curtails the mass utilization of Home Depots paint mixing stations, which represent an integral part of the store modernization. The Company offers a variety of installation services expanding its market share based on the uniqueness of the Home Depots core competencies and value chain. Home Depot has recognized an opportunity for increased market share by examining mega trends in the growth of the Hispanic population and the aging population. Eighty-five percent of the nations homes were built prior to 1980 and will be in need of frequent repair heightening the future opportunity of the do it for me sector of Home Depot customers. Services provided by Home Depot include the installation of carpeting, hard flooring, cabinets, water heaters, and solid surface countertops through qualified independent contractors in the U.S. and Canada, lending itself out as a unique service provider to the consumer. Bargaining Power of Buyers Home Depot buys store merchandise from vendors located throughout the world and is not dependent on any single vendor establishing the Companys bargaining power, relative to that of the suppliers, high. Merchandise is bought directly through the manufacturer and shipped to stores through transit facilities. Home Depot employs a global sourcing merchandising program into its core strategy to source high-quality 15

products directly from overseas manufacturers. Product development associates travel internationally to identify opportunities to purchase items directly for Company stores eliminating the middleman costs allowing Home Depot to develop a price sensitive product selection for the consumer and increase the Companys gross margin. HD has established strategic alliances with certain suppliers to market products under a number of proprietary and exclusive brands. Home Depot has two sourcing offices located in Shanghai and Shenzhen, China, and has a product development merchant located in Bonn, Germany. These assignments allow HD to advance product features and quality, to import products not currently being offered to customers and furthers the operating strategy of offering premium products at a lower cost than would be available through a third-party vendor. Bargaining Power of Suppliers Home Depots suppliers are numerous with no supplier playing a major contributory role critical to the Companys business. HD currently source products from more than 500 factories in approximately 40 countries. The Home Depot, Inc. has initiated a quality assurance program to measure factors such as product quality, timely shipments, and fill rate of all vendor performance. The quality assurance program has established a strict standard to which product performance must adhere. Product testing prior to purchase ensures the compliance of product requirements with HD specific policies. Home Depot systematically evaluates product quality and factory performance by conducting inspections at the factory to assure continued compliance with HDs product requirements. The retail (home improvement) industry allows Home Depot to

maintain considerable power over vendors because of their large buying power and relatively low switching costs. 16

Competitive Strategy The Home Depot, Inc. has positioned itself within the industry based on a strategy of cost leadership. This operating strategy allows the Company to earn above-average profitability by dictating prices from suppliers lowering input costs and minimizing distribution transactions eliminating the middleman. HD has developed a tight-cost control system through quality assurance program that monitors vendor compliance with Home Depot requirements. Home Depot has positioned itself for future business by generating distinctive store formats to accommodate a diversified customer base allowing HD to compete in niche markets such as lawn and garden and the private contracting of home installation. Home Depots core competencies are centered upon the timely execution and delivery of products to its stores to consistently providing an inventory of competitively priced premium products. Achieving and Sustaining Competitive Advantage Home Depot must find a viable way to introduce new business segments and services into the company structure while maintaining the image of comparable highquality value merchandise and service. The sustainability of Home Depots competitive advantage is based on the Companys ability to control cost at the source while providing superior product variety and customer service. Key success factors for The Home Depot, Inc. are the stability of costs and availability of sourcing channels, lowering input costs through monitoring of vendors, and concurrently escalating efficiency at all levels for the end-consumer. Home Depot currently has both the resources and capabilities to maintain these key success factors. Improved inventory management resulted in lower shrink levels for imported products, and enhanced service associates contributed to an increase in average ticket growth in every selling category, with an average of 8.2 percent, from

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$4.13, to $54.73, in the second quarter of fiscal 2003. Fluctuations in the U.S. economy, the Companys ability to retain highly qualified associates, unforeseeable and unusual weather conditions, and the impact of competition remain deterrents to maintain a profitable going-concern for The Home Depot, Inc. Home Depots value chain is expanding to accommodate a balanced consortium of customers. The value chain includes the introduction of paint centers, tool rental centers, trained associates, increases in technology, and store modernization customizing formats to the needs of the market. Applying The Cost Competitive Strategy Home Depot has maintained a competitive strategy to date through the integration of low transaction costs, premium quality merchandise, and specialized services to meet the demand of growing niche markets. HD has developed a growth strategy anchored in continuously assessing opportunities to increase customer loyalty, increase sales, and further market penetration. The Home Depot, Inc. grew service revenues by approximately 27 percent to $883 million in fiscal 2003. In fiscal year 2003, HD acquired White Cap Construction Supply, Inc., to operate 74 Pro distribution branches across the country. Home Depots strategy remains strengthening its core competencies through quality assurance and consistent competitive prices. Expansion of tool rental centers to 925 stores in the United States, the purchase of 20 Home Mart stores in Mexico, and the operation of 1,788 stores in the U.S. are attributed to Home Depots key success factors and competitive cost strategy.

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III. Accounting Analysis The Home Depot, Inc. Accounting Policies The retail industry, in general, presents a very competitive market with high price competition and low product differentiation. Although almost any retailer, from supermarkets to superstores, can offer home improvement items at a competitive price, the home improvement industry currently provides a great opportunity for differentiation in regards to the types of services home improvement retailers offer. To successfully maximize sales and increase revenues in the home improvement industry, retailers such as Home Depot must successfully combine product variety, quality and price and specialized services. As discussed earlier, Home Depot has adopted a business strategy based on these key factors. Consequently, as we look at Home Depots overall financial results, it is necessary to focus on key accounting policies adopted by the company to measure critical factors and risks. In the Managements Discussion and Analysis of Results of Operations and Financial Condition of The Home Depot, Inc 2003 Annual Report (www.homedepot.com), management identified three major areas as areas of critical accounting policy and discussed the adoption of four different accounting pronouncements. In addition to the four recently adopted accounting pronouncements identified in the managements discussion, The Home Depot identified four other major accounting policy changes in its Notes to Consolidated Financial Statements. Specifically, The Home Depot adopted four different accounting pronouncements in regards to service revenue recognition, vendor allowances, goodwill amortization and stock based compensation. The three critical accounting policies, as identified by The

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Home Depot management refer to the treatment of merchandise inventories, self insurance and revenue recognition. Merchandise Inventory policy is specifically addressed by The Home Depot management in Managements Discussion and Analysis of Results of Operations and Financial Condition and is assessed in two different ways. Approximately 93% of total inventory is valued at the lower of cost or market utilizing FIFO under the retail inventory method with the other 7% valued under the cost method. The Notes section of the Financial Statements accounts for the two different methods. According to the Notes, the 7% of inventory valued under the cost method was due to inventory policy of certain subsidiaries and distribution centers. In addition, The Home Depot, Inc. takes a physical inventory count on a regular basis at each store to verify that inventory amounts in the merchandise inventory section of the Consolidated Financial Statements are accurate. Lastly, in regards to merchandise inventory, the company does account for possible inventory shrinkage or swell based on historical results and industry trends. Self Insurance accounting policy for Home Depot addresses its treatment of losses related to general liability, product liability, workers compensation and medical claims. The total liability is estimated on the total cost incurred as of the specific balance sheet date and is not discounted. The estimate is based on historical data and actuarial estimates. The company also explains in its Management Discussion that they ensure estimates of liability are as accurate as possible by having both management and third-party actuaries review the estimates on a quarterly basis. Revenue Recognition is the third critical accounting policy identified by The Home Depot management. Revenue recognition at the Home Depot follows the industry

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norm of recognizing revenue when the customer takes possession of the merchandise or, if a customer makes payment prior to take ownership of the merchandise, Home Depot records the sale as Deferred Revenue on the balance sheet until the sale is finalized when the customer takes possession of the paid merchandise. Additionally, because The Home Depot also provides a variety of services through their installation and home maintenance programs, they also recognize service revenue at the time when the service is completed and also record any customer pre-paid service revenue as Deferred Revenue on the balance sheet. Lastly, Home Depot management discusses four accounting pronouncements dictated in 2003 that could possibly affect their 2003 Consolidated Financial Statements. The first pronouncement, Staff Accounting Bulletin No. 104 (SAB 104)1, issued in December 2003, addresses the SECs view on the treatment of revenue recognition in accordance to GAAP. According to Managements Discussion, this pronouncement had no affect on their consolidated financial statements. The second pronouncement, Statement of Financial Accounting Standards No. 150 (SFAS 150), Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity2, issued in May 2003, did not have any impact on the Home Depots 2003 Consolidated Financial Statements according to Managements discussion. The primary reason for the lack of impact is because of SAFS 150s effective date. SAFS 150 applies only to instruments entered into or modified after May 31, 2003 or at the beginning of the first interim period beginning after June 15, 2003. The third accounting pronouncement was issued in April 2003. Statement of Financial Accounting Standards No. 149 (SFAS 149), Amendment of Statement 133 on Derivative Instruments and Hedging

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Activities3 again did not affect Home Depots 2003 Consolidated Financial Statements because of its effective date. The amendment affect contracts entered into or modified after June 30, 2003 and were integrated into the consolidated 2003 statements. The last pronouncement, a revision the FASBs Interpretation No. 464, requires Home Depot to consolidate any variable interest entities if a companys variable interest absorbs a majority of the entitys losses or receives a majority of the entitys expected residual returns, or both. The FASB requires any company falling into this situation to consolidate the entity in the first reporting period that ended after March 15, 2004 and so Home Depot committed to integrate the change in the first Quarter of 2004. Home Depot does comment on almost all portions, assets (revenues), liabilities (expenses) and owners equity, of their financial statements items relevant to accounting policy for each line item. Most of their policy statements are detailed while other portions are vague or generic in terms of applied numbers. However, The Home Depot does disclose changes for most of their critical accounting policies in either the Managers Discussion or in the Notes to Consolidated Financial Statements. Degree of Accounting Flexibility The Home Depot, Inc. has an average degree of flexibility, as do many in the retail industry. For example, most retail companies have flexibility in selecting their policy on inventory valuation. The Home Depot chose FIFO in comparison to LIFO, for example, and combines both cost and retail methods in inventory valuation. A comparison of Home Depots depreciation policy to those of similar retailers shows consistency in the depreciation schedule of various fixed assets. Home Depot also has an option on how to depreciate or amortize intangible assets, such as goodwill, and a comparison to their largest competitor, Lowes Home Improvement, provides another 22

example of differing accounting options and decisions. Oppositely, the company has very little option in how they recognize revenue, either sales or service revenue, as discussed under Managements discussion; Home Depot was recognizing service revenue at the time the service was completed prior to the issuance of SAB 104. Home Depot had to, overall, address four different accounting pronouncements in 2003 limiting some of their accounting flexibility. Another aspect of The Home Depots accounting flexibility is evident within their financial statement disclosures. A comparison of the Managements Discussion of Financial Results and Notes to Consolidated Financial Statements for The Home Depot and Lowes Home Improvement yields much more data in The Home Depots documents. Some general examples include The Home Depots disclosure of financial data in table form comparing the last 2 years to the current 2003 statements and summarizing, within the notes, the overall impact of the accounting policies, changes to specific accounts, and/or changes to liabilities or estimates. In some cases, it specifically lists future estimates and the impact of those estimates for the upcoming financial period (2004) as in the notes regarding capitalization of interest expense on capitalized leases. Accounting Strategy Further analysis of key accounting policies and advantages and disadvantages can help us better identify some of The Home Depots actual accounting strategy. The use of FIFO vs. LIFO in inventory valuation can tell give us some information on The Home Depots accounting strategy. We can only assume that FIFO is utilized by The Home Depot because most inventories in the retail industry are a FIFO physical flow. Secondly, although LIFO would lower taxable income, LIFO could be utilized to manipulate net income (liquidation of older layers at historical costs could affect COGS 23

and consequently, net income). In the retail industry, FIFO more closely matches Just In Time Inventory because of high inventory turnover in the industry overall. From an operational management standpoint, FIFO also provides higher profits at higher price levels. We assume from sections of Managements discussion and from an industry tendency, that bulk purchases of inventory usually involve discounts from manufacturers. FIFO then allows the Home Depot to sell at a higher price to the consumer translating into higher profit margins for the firm. Managements Discussion partially attributes a higher gross profit, an increase of 13.7%, to Improved inventory management, which resulted in lower shrink levels, increase penetration of import product, which typically have a lower cost. Overall, inventory management can have a dramatic impact on both balance sheet and income statement results. Other items that must be analyzed to help identify actual accounting strategy are accounting pronouncements mentioned in the Notes section of the 2003 Consolidated Financial Statements. Perhaps the most impacting of these pronouncements was EITF 02-16, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor. EITF 02-16 states that cash consideration received from a vendor is presumed to be a reduction of the prices of the vendors products or services and should, therefore, be characterized as a reduction in Cost of Merchandise Sold. According to the Managers Discussion, The Home Depot received consideration in the form of advertising allowances. Prior to the adoption of EITF 02-16, this had the affect of increasing intangible assets (prepaid advertising) and decreasing advertising expense. In both 2001 and 2002, advertising allowances provided by vendors exceeded gross advertising expense by 31 million and 30 million respectively and were recorded as

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reductions in COGS. Again, this reduced expenses and maximized net sales, increasing net profit. However, The Home Depot does disclose, in their 2003 Consolidated Financial Statements, the affect of the change at the end of the 2003 fiscal reporting period and estimated changes in COGS (decrease), the increase in operating expense and the reduction in inventories on a Pro Forma table within the Managers Discussion. Another actual accounting strategy can be analyzed in the treatment of Cost in Excess of Fair Value of Net Assets Acquired. According to the Notes, The Home Depot stopped amortizing goodwill effective February 2002 (under SFAS 142, Goodwill and Other Intangible Assets). Accordingly, Home Depot recorded impairment charges of $0 in 2003, perhaps inflating assets on the balance sheet and deflating expenses on the income statement. Yet another example of accounting strategy is The Home Depots policy regarding capital leases. The company discloses in its Notes that it exercised its option to purchase certain assets in December 2003 that were previously leased in an off-balance sheet agreement with a special purpose entity. However, not until late in the financial period does the company acquire the asset with a related expense for fair market value and related depreciation expenses. One last item that should be mentioned is the inclusion of assets from both the Canadian and Mexican subsidiaries. In comparison to U.S. federal taxes, foreign taxes liability accounted for only 5% and 3% in 2003 and 2002 respectively while federal tax liability account for 82 % and 83% in 2003 and 2002 respectively. Based on the analysis of these accounting strategies and changes in strategy in 2003, our assertion of The Home Depots actual accounting strategy would be that The

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Home Depot practiced an aggressive accounting strategy where assets were maximized and expenses were minimized. Quality of Disclosure Qualitative Analysis of The Home Depots disclosure should be discussed. It is our opinion that there is more than adequate discussion of business strategy and risks in The Home Depots 2003 Consolidated Financial Statements. Specifically, in the Chairmans Letter, Bob Nardelli, Chairman, President and CEO, summarizes the overall fiscal year 2003 results and financial condition and well as key initiatives. Additionally, there is sufficient detail disclosed on policy and changes in policy during 2003. Not only is policy disclosed, the company goes a step further and discloses projections to account for those changes as exemplified in their disclosure of the effect of EITF 02-16, the changes in capitalized lease policy as well as financial projections of this change into the first quarter of 2004 and in discussions such as the reasoning for an increases in SG&A expenses. One shortfall, however, does exist in the quality of segment reporting, which is almost non-existent and could be broken out into geographical segmentation, to account for U.S. results versus Canadian and Mexican subsidiary results or into product segmentation, given the listing of initiatives such as tool rental, flooring, proservices, appliance sales and lawn and garden sales. Overall, we deem The Home

Depot to be forthcoming in their accounting policy and assess the quality as good to excellent. Quantitative Analysis of the Companys accounting should also be addressed. Because the Company is in the retail industry, and as asserted earlier, has to be measured on items such as inventory, we will consider certain sales and expense diagnostics as follows: 26

Potential Red Flags The existence of a special purpose entity with regards to Capital Leasing options for certain assets (distribution centers, warehouses, retail locations and office space) was established for the purpose of leasing these assets off the balance sheet. As discussed in the Notes to the 2003 Consolidated Financial Statements, the Company took their option to purchase the assets and include the asset on the consolidated balance sheet for fiscal year 2004. Once the option to buy the assets was made in December 2003, the special entity was dissolved. All policy regarding this transaction as well as a discussion

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of the impact of this decision are disclosed in the Notes to the 2003 Consolidated Financial Statements.

Notes
1. Revises or rescinds portions of the interpretative guidance included in Topic 13 of the codification of staff accounting bulletins in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The principal revisions relate to the rescission of material no longer necessary because of private sector developments in U.S. generally accepted accounting principles. Also rescinds the Revenue Recognition in Financial Statements Frequently Asked Questions and Answers document issued in conjunction with Topic 13. Selected portions of that document have been incorporated into Topic 13. U.S. Securities and Exchange Commission [on-line]. Selected Staff Accounting Bulletins: SAB 104; available from http://www.sec.gov/interps/account.shtml; Internet; accessed 28 September 2004. 2. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements. Financial Accounting Standards Board [on-line]. FASB Pronouncements: Statements of Financial Accounting Standards; Statement 150; available from http://www.fasb.org/st/#fas150; Internet; accessed 28 September 2004. 3. This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. Financial Accounting Standards Board [on-line]. FASB Pronouncements: Statements of Financial Accounting Standards; Statement 150; available from http://www.fasb.org/st/#fas149; Internet; accessed 28 September 2004. 4. This Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, addresses consolidation by business enterprises of variable interest entities,* which have one or both of the following characteristics: The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity. 1. The equity investors lack one or more of the following essential characteristics of a controlling financial interest: a. The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights

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b. The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities c. The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses. Financial Accounting Standards Board [on-line]. FASB Pronouncements: Summary of Interpretation #46; available http://www.fasb.org/st/summary/finsum46.shtml; Internet; accessed 28 September 2004. IV. Ratio Analysis and Forecasts Introductory Section: Purpose of this section: The fundamentals behind Home Depot look good and have proven profitable, but it is necessary to evaluate the company based on its actual numbers and analyze that against the competition. It is possible to use analytical methods to take into account business factors and outside factors that will affect the firm and predict the economic effects on the firms financial statements. Methods employed in this analysis include, time series analysis, cross-sectional analysis, ratio analysis, prospective analysis, analysis by charts. A general idea of the opportunities facing the firm and how well the firm has already exploited its opportunities can be gained by doing this analysis. It is beneficial to current and potential investors to see the potential performance of an investment in this particular company. Financial Ratio Analysis Section: In this section, five years of annual data filed with the SEC have been used to perform a ratio analysis of Home Depot and evaluate the companys liquidity, profitability, and capital structure. Specific ratios that are chosen for this industry outside of the basic 14 are there because they represent a pertinent success factor for the business.

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Ratio Analysis Liquidity: Home Depot appears to be a solid company after computing relevant ratios. A few ratios indicated that there may be some change in capital structure and operating efficiency. Overall, no significant problems exist. Home Depot is not struggling to pay its debts to creditors. The quick ratio trends upwards while, the ability to pay current debts has shown a downward trend. This trend is not a cause for concern because some debt has been generated from expansion into the Chinese and Mexican markets. Because Home Depot collects payments (cash or other means of payment) at the point of sale, the days receivables outstanding are low. Home Depot offers credit cards, mainly to contractors and frequent shoppers; this is the main thing keeping the receivables ratio from being even better. Another key ratio is the days supply of inventory, being that Home Depot is a retailer. The days supply of inventory is fairly stable (Days supply is currently 71.84) with a slight increase in last years data, not a large enough increase to cause concern of obsolescence or impairment. When compared to Lowes, Home Depot looks very similar in terms of liquidity. Lowes collects is receivables a bit quicker and maintains a higher current ratio at 1.4, but they hold quite a bit more inventory. Lowes is the main competitor of Home Depot and it makes sense that their measures of liquidity would not stray too far from each other. Profitability: Both Home Depot, and Lowes are profitable companies that seem to have good years together and decline together. The industry shows a trend to move upwards with small increases in profitability. Home Depot operates on a gross margin above 30% and

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the net margin is nearly 7%. This margin is somewhat thin compared to other industries but is wider than its competitors. The Home Depot is profitable because it generates large amounts of sales and can take smaller profits on each sale. One measure of profitability that did stand out concerned the operating expense ratio. Lowes operating expense ratio has remained flat over the past five years and Home Depot has gone up slightly. I do not believe this increase is significant or is a sign of management problems. Selling, general and administrative expenses as a percent of sales have increased slightly. The return on assets and return on equity ratio depicts that Home Depot manages its assets better than Lowes and manages to generate a greater return on assets and return for shareholders. 2004 ROE Breakdown ROA = Net Income/Sales x Sales/Assets 4304/64816 x 64816/34437 0.664 x 1.8822 0.125 ROE = ROA x Assets/Equity 0.125 x 34437/22407 0.125 x 1.5369 0.1921 Capital Structure: Compared to Lowes, Home Depot uses much less debt financing, whereas Lowes uses over a third of debt financing. Both companies have the ability to make good on their upcoming debts. In 2002 and 2003, Home Depot utilized more debt in acquiring their basis in Mexico causing a surge in their debt to service ratio. Once purchased, their service ratio decreased again to within an industry average in 2004.

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Other Ratios: Home Depot is paying their debts slower; this can be seen in the days payables and turnover ratios. This does not seem problematic because in past years Home Depot paid much quicker than Lowes, now their ratios are the same. NOPAT and EBITDA margins were included to show any differences between Lowes and Home Depot in terms of non cash expenses since EBITDA does not include depreciation or amortization. NOPAT shows the company in light of operating policy and excludes debt policy. Both these ratios for both companies are very similar and show that they operate similarly. Other Ratios were included to show how Home Depot chooses to manage its long term assets relative to Lowes. They are both retailers, neither holds much cash on hand to cover any debts that may arise immediately, both have similar policies for long term assets in turnover and asset use. The sustainable growth rate for home depot at the year end of 2003 is 0.22 whereas the growth rate for Lowes is 0.19. The sustainable growth rate for Lowes has consistently been lower than that of Home Depot for all years analyzed here. Home Depot has shown strong growth in past years but that growth will probably slow down below what is sustainable. Financial Statement Forecasting Methodology Section Method for forecasting Quarterly income statement: Sales have been about 23% for Q1, 27% for Q2, and I have forecasted that sales will continue to be 25% of annual sales for Q3, with the other 25% coming from Q4. I assume slower growth than is predicted by past trends. The growth seems well above the industry average and I still make the assumption that sales will grow at 11% indefinitely. The sustainable growth rate suggests that the company can grow at nearly 20%. An

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average companys sales would be around 9% and Home Depot is an above average company. Cost of Goods Sold shows a slight decreasing trend in recent quarters. I would expect to see a further decrease in costs to 67% of sales for the year. Costs are expected to show a further decline in the future 10 years and I believe they will become stable at 65% of sales growing at a rate of 10%. Total Assets/Sales waver near the 2.0 mark, so I make the assumption that total quarterly assets will be twice sales. A sporadic decline in the growth of long term tangible assets can be observed; a level of 60% of total assets will be assumed for tangibles at the beginning and end of the fiscal year; continuing to fall to 55% in other months. There is a closer relationship and superior trend between inventory/total assets than inventory/sales, therefore inventory will be maintained at 25% of total assets and 1% higher for the beginning of the fiscal year as long as it continues to reflect the current level of sales. A trend has been established where more cash and marketable securities are held late in the year and fewer in the beginning. A level of 13% of sales at the end of the year and 9% of sales at the beginning are assumed, both numbers based on past data that will continue. Long term intangibles show no sign of changing and are expected to remain the same percentage of assets they are presently, 3.5%. Method for forecasting quarterly Balance sheet: The ratio of debt to equity has been stable for the past five years (approximately 0.06) I have no reason to believe this ratio will change. Home Depot has taken on more short term debt than previous quarters but I do not believe this to have the ability to significantly change the structure of Home Depots financing.

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There is no specific quarterly trend in common shareholders equity except that it shows slight infrequent decreases, equity will be assumed to remain at 58% of total liabilities and shareholders equity for the remainder of the fiscal year. Short Term Debt will remain unchanged for the next two quarters, as it has for the past year. A trend that has been interesting is that Home Depot is making good on its payables more slowly (days payables increasing). I dont expect to see a significant increase in payables over the next two quarters because Home Depot does not appear to have a cash shortage, so the payables balance is left at 19% of total liabilities and equity. Other current liabilities show a trend of remaining relatively flat over past years. Other long term liabilities show a stronger upward trend than long term liabilities so a 7% growth rate based on growth in past data will be assumed. Method for forecasting annual Income Statement: From the quarterly income statements it can be assumed an 11% growth in sales and 10% growth rate for cost of goods sold will continue into the future. It is my assumption that growth in cost of goods sold will decrease around 2009 to remain at about 65% of sales. Selling, general and administrative expenses as percent of sales tends to fluctuate around 20% of sales in quarterly, and annual data, I forecast it to remain at 21% of sales. Other operating expenses are assumed to remain constant and continue to be 90 million for forecasting purposes. As stated in the notes to the financial statements, the effective tax rate is 37%. This was used to calculate future tax expenses.

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Method for forecasting annual Balance Sheet: From my quarterly forecast I can say that assets for 2005 will be 39930, then for subsequent years I will assume them to be 53% of sales. Because the fiscal year ends in the middle of January and I forecasted the quarterly statements to end then I will transfer the balance sheet values to year 2005 in the annual forecast. Accounts Receivable tends to remain at about 3.5% of total assets in past data, see no reason to forecast a change. For the annual forecast, I will assume that inventory is 14% of sales instead of using the common size data simply because the sales data seems to more closely approximate the appropriate amount of inventory. Cash and Marketable Securities are held at a 4% of sales. I calculated other current assets by working backwards into them from an assumption that current assets make up a bit more than a third (38%) of total assets. Long term tangible assets are 58% of total assets and intangibles are 2.5% and are expected to be the same percentage in the future. I worked backwards into other long term assets after calculating other values, since total assets have already been calculated. Short term debt shows a large increase this quarter. In managements discussion of results, management cites growth plan in areas such as the Floor store section of their business and improvements in their existing stores in an effort to modernize some older buildings. Our assumptions are that Home Depot assumed a larger short term debt to finance these improvements. We expect this level of debt to normalize over the next year as these improvements are short term investments in capital assets. Accounts payable show faster growth relative to sales growth, this trend is expected increase to 13% by 0.5% per year and remain at this level. Total Current Liabilities show no specific trend as a percent of total liabilities and equity or as a percent of sales (except that it is 35

increasing). Current Liability growth does seem to track growth in total current assets. Current liabilities have grown faster than current assets, bringing the current ratio down in the past where it is currently at 1.4. I will continue the trend into 2005 it is not my belief that home depot will maintain the ratio here. It makes more sense to bring the ratio closer to 1.5, where it will be in the long run. Long term debt is becoming a smaller and smaller percentage of total sales and total liabilities and equity. I would not expect the decreasing trend to continue any longer past 2005. Equity shows a consistent trend of being 32% of sales and it is forecasted to continue. Method for forecasting annual Cash Flows: Home Depot hasnt strayed too far in terms of performance on a cash basis against performance on an accrual basis. This is a good sign for the quality of accounting. We also assume that all balance sheet ratios will increase proportionately with the sales growth rate. There arent any significant faults to be observed in the cash flow of Home Depot, and future prospects for the firm look good as well. I calculated the forecasted cash flow information by starting with a comparison of cash to sales. I then took the data as a percent of sales for forecasting purposes. Conclusion: Home Depot appears to be a solid company that has recorded good performance in past years. A prospective analysis of the company shows that future growth prospects look good. Ratio analysis against the main competitor, Lowes, shows that Home Depot is performing above the competition. Investors have rewarded Home Depot with better stock price performance than that of the industry and the competition. Expansion into other countries will fuel growth and make future financial estimates more appealing. I would expect Home Depot to perform well in the future.

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Note: The industry graph, located in the appendix, shows the performance of the specialty retailer (home improvement retail) industry as compared to Home Depot, Lowes, and the S&P 500. Home Depot has outperformed the industry, the S&P, and its main competitor, Lowes over 3 months. The Lower chart shows the year to date performance of Home Depot; it shows that Home Depot, Lowes, and the S&P all track the industry to some extent and that Home Depot consistently outperforms the industry and its competitor. V. Valuation Introduction After forecasting the financial statements for Home Depot, for ten years into the future, it is essential to put these values into models in order to determine the value of the equity. These values are based on assumptions of the future performance of the company. This section will focus on discounted values at the cost of capital to the company. It is important that these valuations be done for several reasons. The market consensus of the value of the firm should be compared to our calculation of intrinsic value to determine if the stock is an attractively priced security. Depending on the level of confidence we have in our forecasts and assumptions about the future prospects of the firm, we will determine how accurate the valuation model is. Some models carry more weight than others, but it is necessary to have valuations across a broad range of variables. These valuations can also assist in assessing where the market thinks most of the value of the firm lies, either in assets that are already in place, or in the firms future.

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The specific valuations/models to be discussed in this section are: Method of Comparables Discounted Dividends Discounted Free Cash Flows Discounted Residual Income Abnormal Earnings Growth Altmans Z-score

A sensitivity analysis has been performed where the cost of capital and the growth rate implied by the market are determined. These implied values can be found on the top of each valuation spreadsheet. Cost of Capital The cost of equity capital used for valuation purposes was calculated to be 11.79% using an equity risk premium of 5.3%. This premium was found from the difference between a long run average of monthly returns on the S&P 500, and a long run average of the returns on 20 year treasury bonds. The long term Treasury bond was used to reduce the effect of short term factors that influence short term rates on t-bills. I computed the cost of equity using both t-bills and t-bonds and I believe that the rate on the 20 year treasury yields a closer approximation of the risk premium. The cost of debt was calculated by using the average rate on long term debt which was found in the notes to the financial statements. Home Depots debt structure is 68% long term debt with an average rate of 4.64%, and 32% short term debt with an average rate of 1.79% (rate on commercial paper). The tax rate used to calculate the after tax rate on debt is 37%.

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Beta was calculated to be 0.99 which is lower than the published Value Line beta of 1.3. Because of the significant difference between these two numbers, which can be attributed to short term market factors affecting the firm return, I feel that the Value Line beta is a better number to use for the purpose of valuation. Home Depot seems to hold more risk than the average market risk because of the cyclical nature of the home improvement retail industry. WACC = (Kd (1-T)) (Vd/Vf) + Ke (Ve/Vf) WACC = (0.0464(1-0.37) (15881/38331) + 0.1179(22450/38331) WACC = 8.12% The Weighted Average Cost of Capital was found using the values stated above with the knowledge that approximately 41.5% of the firm is financed with debt and 58.5% is financed with equity. The WACC is 8.12%. Method of Comparables Valuation The method of comparables valuation was performed using current share prices and shares outstanding. This method requires that several close competitors of Home Depot be used to compute ratios and then be averaged. Home Depot most closely competes with Lowes, but more than one competitor is required for the method of comparables valuation. Five companies were chosen based on market share, and products sold, and sector of the industry served. Most companies serve home consumers and contractors, but some focus more on commercial customers. The Building Materials Home Corporation mainly is a construction services provider. The Fastenal Company is a wholesale distributor of construction supplies. This company may not directly compete with home depot, but the companies share several similar products and for valuation purposes, are comparable. Sherwin Williams 39

Company is involved mainly in the selling of paint and paint supplies. This is more of a specialty store, but is considered a competitor with Home Depots Expo centers, and Home Depot because of similar product sales. Tractor Supplys customers are ranchers and tradesmen. It sells a wide range of products and can be considered a home improvement retailer even though it targets mainly agricultural customers. Tractor Supply most closely competes with Home Depot in sales of hardware. Lowes is the most clear and accurate comparison to Home Depot. They directly compete with each other and stock nearly all of the same products. The comparables valuation is not considered to be one of the most accurate measures, as can be seen by the range of values. This range could be caused by a lack of close competitors due to a concentrated retail home improvement industry. The price earnings ratio most accurately estimates the actual price of Home Depots shares. The price to sales ratio was the furthest off, possibly because of the different sizes of the companies used in the valuation. Revenues vary between the retailers because of company size and market share. According to this valuation model, Home Depot is overvalued. Intrinsic Valuation Methods Discounted Dividends The Discounted Dividends method of valuation holds more weight in this valuation process than does the method of comparables, mainly because of the lack of direct competitors in the industry. Variation in price is not explained well by the variation in dividends over time. The historical dividend growth rate shows some consistency, so this rate was used in forecasting of dividends. Steady dividend growth is expected to be seen in the future.

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The cost of equity capital was used to discount the future dividends back to 2004. The total present value of the forecasted 10 years of dividends amounted to 2.75 while the terminal value, which was calculated assuming no growth on the dividend paid in year 2014, amounted to 6.60. The stock is extremely overvalued according to this model. I do not feel that the estimates of the forecasted values of net income are too conservative. Moderate growth was forecasted and this would cause future dividends to be smaller. A sensitivity analysis of the Dividend Discount model shows that a 2.05% cost of equity capital, or a 9.8% growth factor in the terminal value, would equate the value of the equity with the market price. The implied cost of equity is not reasonable, but growth is very reasonable and probable. Discounted Free Cash Flows Contrary to the discounted dividend model, the free cash flow model showed the market price to be smaller than the intrinsic value of the stock. This model has more explanatory power than the previous two models and carries more weight in the overall valuation of Home Depot. The terminal value of the free cash flows is calculated using the expected 2014 free cash flow. The free cash flows have been showing a decreasing trend according to the forecast, but I do not expect this trend to persist into the future. The estimated share price according to this model is 51.10. After a sensitivity analysis of growth in the terminal value and sensitivity of the weighted average cost of capital it can be determined that the market assumes a 9.69% weighted average cost of capital. Because the intrinsic value is higher than the current market price, we would have to assume either a higher weighted average cost of capital, or negative growth to equate the market price with the intrinsic value. 41

Discounted Residual Income The discounted residual income valuation model has the most explanatory power of all the models discussed so far. It links uses dividends to link book values to market values. For this model, we will assume normal earnings to be calculated by: last years earnings multiplied by 1+Ke. Because this model values the spread between expected earnings and normal earnings, it cannot grow in an unbounded manner like discounted free cash flows. Hence, we are valuing the residual income on a per share basis. For this model, the implied cost of equity capital that will equate the current stock price with the intrinsic value is 8.62%. The growth rate to equate the market value to the intrinsic value is 8.9%. I feel that the implied cost of equity is slightly low for this stock, but the growth in the terminal value is not unreasonable here. There is an increasing trend in residual income which implies growth in the terminal value. According to this model, the market price is overvalued by quite a bit. The value is estimated to be 24.74. The calculation of the relative values will show where the value lies in Home Depot. Assets already in place make up 40% of the value, the present value of residual income makes up 37% of the value, and the future potential of the firm measure by the terminal value makes up the other 23% of the firms estimated intrinsic value. This explains that Home Depot is somewhat of a mature firm with a large percentage of assets in place which lowers the risk of investors. The firm has 23% of its value coming from future potential which can be seen as a sign of positive future performance. Long Run Average Residual Income Perpetuity This residual income valuation is calculated by taking the difference between the expected long run return on equity and the cost of equity. This difference is then used to

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find a perpetuity while accounting for growth in the book value of equity. The return on equity for Home Depot has been quite stable over the past five years, and I do not forecast any significant changes in structure. The long run return on equity is 19%. The historic growth in book value of equity has not been a constant value. There has been significant fluctuations in this value, and the valuation will be done once assuming no growth, and once with the implied growth rate. For forecasting purposes, the growth rate is determined to be 11%. P/B = 1 + (ROE - Ke) / (Ke - gbve) P/10.23 = 1+ ((0.19-.1179) / (.1179-0)) P = 16.49 (assuming no growth in book value)

The Implied growth in book value of equity for this valuation is 9.49% which I believe to be an attainable value. This model implies that the cost of equity is very low, 4.6%. In this model the stock is overvalued. The discounted residual income model is a better valuation method for Home Depot and seems to better represent the market consensus price. Abnormal Earnings Growth Valuation The objective of this valuation model is to value a stock with the assumption that dividends are irrelevant. To do this it is necessary to assume that the dividend will be reinvested at the cost of equity capital. The difference between the cumulative dividend earnings and the normal earnings are the abnormal earnings. The total discounted abnormal earnings growth added to the earnings per share and the present value of the terminal value will be the estimated price.

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Our abnormal earnings seemed to have a significant amount of variation. To reduce the variation I chose to take the average of the forecasted abnormal earnings to find the terminal value. If I had used the final years abnormal earnings, the stock would have been extremely overvalued, which, based on the fundamentals of the business, I do not believe to be the case. A cost of equity capital that is implied by the market was found to be 9.45%. The implied growth rate is 10.20%. The terminal value was calculated assuming no growth in abnormal earnings. Altmans Z-Score Z-Score based on year-end 2003 Annual report with the Market Value of Equity based on the current market price of $42.29 which was the same price used in our valuations. Home Depots Z-Score fell higher than the 2.7 score required for credit worthiness and falls in line with the estimated cost of debt.

Results and Conclusion These valuation models offer a nice breakdown of the business and give explanations of where the value of Home Depot is derived from. In the residual income model, it was determined that most of Home Depots value comes from assets that are already in place. Based on the valuation models used, Home Depot is overvalued in all models except for the discounted free cash flows model. The method of comparables valuation for the price earnings ratio was only slightly overvalued.

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Specific reasons for the difference between the value determined by a market consensus and by these models are as follows: The estimation of the cost of equity and the equity risk premium has a significant effect on the estimated value of the stock. For a company with most of its value in assets already in place, the estimated cost of debt may have been slightly high. If this were true, then the stock would be only fully valued. Another factor that would have a substantial impact on the valuation is the forecasts the valuations are based on. After comparison of these forecasts against published forecasts, it is evident that the forecasts used in this valuation are more conservative in terms of sales growth and earnings growth. This would have a similar effect that overestimating the cost of capital would have. I am confident that using the published beta of 1.3 instead of the beta determined in the regression analysis has yielded more accurate results. Because the forecasts used in this valuation are on the conservative side, I would say that Home Depot is slightly overvalued and while it is not being traded currently at an attractive price, the companys future looks positive. VI. Analyst Recommendation Home Depot is a financially sound company and performs well when compared to its competitors. Based on current business conditions and the potential growth opportunity facing Home Depot, we feel that the bottom line will continue to grow at a healthy rate above the competition in the near future. We believe that the relatively low levels of debt, slightly wider margins, and lower costs make Home Depot an attractive investment for the long run. Shares of Home Depot are currently trading at a premium to what we believe is the intrinsic value. This premium is possibly derived from the markets belief that better than predicted growth will be seen from expansion into foreign markets, specifically China. 45

Home Depot is a well managed business that has had a historically above average performance. Because the shares currently appear to be slightly overvalued, we recommend Home Depot as a hold. Risks to this recommendation include the threat of a possible terrorist attack, and because Home depot operates in a cyclical industry, fluctuations in economic conditions as well. Overall, Home Depot is a strong company that is poised to outperform its industry and the market. VII. References 1. 2. 3. 4. 5. 6. 7. 8. Home Depot Annual Reports/Statements Home Depot company website Zacks.com Yahoo finance MSN Money Edgarscan Value Line BigCharts.com

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VIII. Appendix

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Trend (Time Series) Analysis Home Depot Ratio Analysis Liquidity Current ratio quick asset ratio accounts receivable turnover days outstanding receivables inventory turnover days supply of inventory working capital turnover Profitability gross profit margin operating expense ratio net profit margin asset turnover return on assets return on equity Capital Structure debt to equity ratio times interest earned debt service margin Other operating return on assets NOPAT margin EBITDA margin operating working capital to sales ratio operating working capital turnover accounts payable turnover days' payables net long term asset turnover PP&E turnover cash ratio operating cash flow ratio liabilities to equity ratio net debt to equity ratio debt to capital ratio dividend payout ratio sustainable growth rate

2000 1.75 0.21 72.79 5.01 5.53 66.06 14.06 0.30 0.19 0.06 2.25 0.14 0.19 0.06 -92.88 84.62 0.16 0.06 0.10 0.11 9.03 13.56 26.92 3.68 3.76 0.05 0.67 0.38 0.05 0.06 -0.11 0.21

2001 1.77 0.23 64.33 5.67 5.32 68.57 13.48 0.30 0.20 0.06 2.14 0.12 0.17 0.10 -199.57 698.00 0.14 0.06 0.09 0.12 8.13 16.22 22.50 3.42 3.50 0.04 0.64 0.43 0.09 0.09 -0.14 0.20

2002 1.59 0.53 61.03 5.98 5.63 64.80 13.87 0.30 0.21 0.06 2.03 0.12 0.17 0.07 -176.14 1189.80 0.15 0.06 0.09 0.08 12.22 10.89 33.53 3.42 3.48 0.39 0.92 0.46 -0.07 0.06 -0.13 0.19

2003 1.48 0.41 58.48 6.24 5.33 68.49 15.00 0.31 0.21 0.06 1.94 0.12 0.19 0.07 -157.57 687.14 0.16 0.06 0.10 0.09 11.40 8.80 41.47 3.31 3.39 0.28 0.60 0.52 -0.05 0.06 -0.13 0.21

2004 1.40 0.41 59.77 6.11 5.08 71.84 17.17 0.32 0.21 0.07 1.88 0.12 0.19 0.06 -110.42 12.90 0.16 0.07 0.11 0.09 11.13 8.57 42.57 3.17 3.23 0.30 0.69 0.54 -0.09 0.06 -0.14 0.22

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Cross Sectional (Benchmark) Analysis Lowes 1999 Liquidity Current ratio quick asset ratio accounts receivable turnover days outstanding receivables inventory turnover days supply of inventory working capital turnover Profitability gross profit margin operating expense ratio net profit margin asset turnover return on assets return on equity Capital Structure debt to equity ratio times interest earned debt service margin Other operating return on assets NOPAT margin EBITDA margin operating woking capital to sales ratio operating working capital turnover accounts payable turnover days' payables net long term asset turnover PP&E turnover cash ratio operating cash flow ratio liabilities to equity ratio net debt to equity ratio debt to capital ratio dividend payout ratio sustainable growth rate 0.12 0.05 0.07 0.06 17.53 7.36 49.63 3.00 3.07 0.24 0.49 0.92 0.28 0.29 -0.07 0.15 0.40 13.53 19.55 0.28 0.20 0.04 1.76 0.07 0.14 1.55 0.30 107.54 3.39 4.10 89.07 12.02

2000 1.43 0.21 116.65 3.13 4.11 88.91 15.07 0.28 0.20 0.04 1.65 0.07 0.15

2001 1.63 0.34 133.55 2.73 4.36 83.71 11.62 0.29 0.20 0.05 1.61 0.07 0.15

2002 1.56 0.36 154.02 2.37 4.65 78.44 13.31 0.30 0.21 0.06 1.64 0.09 0.18

2003 1.53 0.40 235.40 1.55 4.63 78.81 13.30 0.31 0.20 0.06 1.62 0.10 0.18

0.54 11.61 26.68 0.11 0.05 0.07 0.06 17.55 7.79 46.87 2.61 2.67 0.16 0.39 1.07 0.46 0.35 -0.07 0.16

0.58 10.36 27.22 0.11 0.05 0.08 0.05 18.28 9.18 39.76 2.51 2.56 0.28 0.53 1.06 0.46 0.37 -0.06 0.16

0.46 13.96 92.97 0.14 0.06 0.10 0.04 28.09 9.50 38.41 2.52 2.56 0.31 0.75 0.94 0.32 0.31 -0.04 0.19

0.36 17.66 40.95 0.15 0.06 0.10 0.03 39.95 8.97 40.68 2.50 2.58 0.37 0.72 0.85 0.21 0.27 -0.05 0.19

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