D.R. Horton ( DHI 0.00%↑ )
In today's market, it's rare to find companies with strong growth, high returns on equity (ROEs), and solid balance sheets that don't also have sky high price-to-earnings (P/E) ratios. However, the homebuilding industry stands out with its 20-30% ROEs, debt-free balance sheets, and double-digit earnings per share (EPS) growth. Remarkably, homebuilder stocks like DHI 0.00%↑ & BLDR 0.00%↑ trade at just 10 times earnings — extremely cheap for the amount of cash the rake in.
This memo will focus on the largest homebuilder, D. R. Horton — which is a completely changed company in a completely changed industry, and one that now deserves to sell at a much higher PE ratio.
In the past, Horton and the other large builders functioned like asset heavy real estate companies. The industry has since shifted; these companies now operate with fewer assets, focusing on efficient construction processes. D.R. Horton, as a more streamlined company, boasts high ROEs and generates substantial free cash flow, leading to an exceptionally strong balance sheet with more cash than debt as of 2023.
And, in many ways Horton is a “growth” company. It is gaining market share at the expense of cost-disadvantaged small private builders. From fiscal year 2018 to 2023, the company's home deliveries and market share have significantly increased, with revenues, profits, and EPS growing at impressive compounded annual growth rates (CAGRs). Horton’s deliveries of homes increased at a 9.8% CAGR from 51,857 to 82,917 (its market share of single-family new homes sales increased from 8.2% to 12.6%), revenues grew at a 17.1% CAGR, profits at a 25.4% CAGR, and EPS at a 29.8% CAGR (from share repurchases). In FY 2023 (which ended on September 30), Horton earned $13.82 per share in spite of high interest rates that made new homes less affordable.
The company projects a continued ~10% annual growth in volumes, indicating an 8-11% increase in revenues and even higher profit margins due to economies of scale, with EPS expected to grow by at least 11% after accounting for share repurchases. This growth outlook is competitive with major corporations like Apple and Microsoft, yet D.R. Horton's shares trade at a much lower P/E ratio of 10.6x its 2023 EPS, offering an attractive investment opportunity.
Given D.R. Horton's quality and growth trajectory, I believe its shares should trade between 16-20 times earnings. If the company achieves an 11% CAGR in EPS and earns $19 by 2026, its share value could rise to $300-380.
Why Homebuilders Deserve Higher Valuations
During the past 60+ years, the S&P 500 Index has sold at an average of just over 16 X earnings. I believe that the large builders are above average businesses in terms of their overall quality and growth—and therefore are worth more than 16 X earnings. In addition to faster revenue growth, D.R. Horton also enjoys a stronger balance sheet and higher returns than the average S&P 500 company (i.e. 16X P/E).
The Rebirth of Homebuilders
Not long ago, the large homebuilders were more real estate companies than manufacturing companies because they tended to own large quantities of land. Real estate companies normally deserve to sell at relatively low PE ratios because they own assets that can become impaired in value and because they tend to be at least moderately leveraged with debt, which increases the risks of financial stress.
Furthermore, the values of the land owned by the homebuilders tended to increase at only a 3-4% annual rate over time—and thus a substantial portion of the homebuilders’ capital was invested in a slow growing asset. Also, because the homebuilders tended to invest a large fraction of their operating cash flows in the acquisition of land, their free cash flows available to their shareholders was diminished.
Importantly, in recent years, other large homebuilders have substantially and successfully reduced the amount of land they own to a very low level — thus, conceptually, they have transformed themselves from being real estate companies into manufacturing companies. This transformation is a major development that, in my opinion, changes homebuilding from being a historically decent business to being a very very good business.
Now, as asset light manufacturers, the large homebuilders earn relatively high returns on their invested capital and generate large quantities of free cash flow. They have been using their sizable free cash flows to reduce their net debt to very low levels (they now have fortress balance sheets) and to repurchase shares—all attributes of a very good business.
Another transition has been occurring in the homebuilding industry. It has been consolidating as many small builders shrink or entirely close their businesses as a result of the difficulties and costs of obtaining financing, land, labor, materials, or regulatory permits. As smaller builders face financial and operational challenges, leading firms like D.R. Horton are poised for faster growth by capturing additional market share. The ongoing housing shortage in the U.S., estimated between 3-5 million units, coupled with the annual demand for new homes, suggests a robust and expanding market for major homebuilders. This environment supports higher valuations, especially when considering the lack of significant threats from international competition, e-commerce, or technological disruptions that other sectors face.
Unlike many industries facing challenges from globalization, e-commerce, or technological advancements, homebuilding is relatively insulated from such threats. The unique nature of each new home, coupled with the industry's current dynamics, supports a case for higher P/E ratios. The question remains whether the market will recognize the value in large homebuilders and adjust their P/E ratios accordingly. Given NVR's historical performance and D.R. Horton's scale and growth, there's a strong argument for D.R. Horton to achieve, if not exceed, a 16x P/E.
Future demand for new homes
As mentioned above, underbuilding during the past sixteen years has created a shortage of housing units in the US. While the demand for new homes can vary some from year to year, the number of families in the United States grows by about 1,100,000 per year—and these families need to live somewhere—so there is a built-in need for new housing. In addition to the net need of about 1,100,000 new housing units per year, roughly 400,000 housing units per year are demolished due to age, damage, location, design, etc. Thus, there is a total need for about 1,500,000 new housing units per year in the United States. When the existing shortage is added to the 1,500,000 annual need, the demand for new homes should exceed the capacity to build new homes, thus creating a tight and growing market for foreseeable future (although, of course, there could be temporary disruptions). The following chart from a Sherwin Williams presentation concludes that “it would take almost of decade of 2,000,000 annual housing starts to make up the (housing) deficit”—and I believe that the industry lacks the capacity to build 2,000,000 new units per year.
Further Reading
This post is a basic overview of homebuilders & the housing market. If you want to learn more, feel free to check out the interesting articles below.
DR Horton acquires water rights in AZ, Nevada, & New Mexico.