Home Depot (NYSE: HD), the world’s leading home improvement retailer, has made shareholders very happy, as the stock has returned more than 800% over the past decade. In the short term, stock prices can fluctuate wildly based solely on investor mood and sentiment. However, over longer periods of time, stock prices tend to follow the underlying fundamentals of a business.

Therefore, the single most important determinant of business value is free cash flow. Home Depot excels in this respect, primarily because of its impressive return on invested capital (ROIC), which was 41% as of the first quarter of fiscal 2020. A higher ROIC allows a company to reinvest less back into the business to achieve a certain level of growth, which translates to higher cash flow. This means more capital is available to pay down debt, engage in mergers and acquisitions (M&A), and reward shareholders via buybacks and dividends.

Let’s dive into why Home Depot is a cash flow machine.

An illustrated rising bar graph leading to a transparent jar filled with coins and labeled "cash flow."

Image Source: Getty Images.

Since the housing crisis

Home Depot’s sales bottomed in fiscal 2009, during the housing crisis and Great Recession. Even in the most troubled time in history for the U.S. housing market, Home Depot was profitable and cash flow positive. As of Jan. 31, 2010, the company operated 2,244 total stores.

In the years since, management has focused relentlessly on increasing the productivity of each individual location, with tremendous success. As of Feb. 2, 2020, Home Depot operated 2,291 stores, which is only a 2.1% increase over the past 10 years. Meanwhile, revenue and profit rose 67% and 323%, respectively, over the same time period. These are eye-popping numbers and demonstrate the untapped potential Home Depot had to create more value from each store. 

The company has continued its focus on improving the shopping experience. In 2017, it launched its multiyear One Home Depot initiative in order to create a seamless, integrated shopping experience that blends the physical and digital worlds. Opening new stores is very capital-intensive, so it’s great to see the company realizing that the strategy of a decade ago is no longer prudent today. Instead, driving foot traffic, customer ticket size, and more frequent transactions is the key for growth going forward.

The capital freed up by not building new stores will translate to more cash flow. Home Depot’s operating cash flow in fiscal 2019 was $13.7 billion, while its capital expenditures totaled just $2.7 billion. No wonder the company continues raising its dividend every year.

Financial metrics

Another factor for Home Depot’s rising cash flow is its margin improvement. Home Depot achieved a 10.2% net margin in fiscal 2019, more than double the 4% net margin registered in fiscal 2009. This was driven by economies of scale, where Home Depot’s fixed cost base is spread over more revenue. I see this trend holding up as the company places less emphasis on opening new locations, which will lower operating expenses and depreciation charges as well.

A cash flow machine like Home Depot must find ways to return its excess capital to shareholders. The company employs a disciplined approach to capital allocation, which includes raising its dividend each year, maintaining a high ROIC, and repurchasing shares opportunistically. In fiscal 2019, Home Depot returned a total of $12.9 billion to shareholders. The company suspended its stock buyback program in Q1 of this year to preserve cash due to the coronavirus pandemic, but I’m confident that management will ultimately resume a generous shareholder capital return policy.

Cash is king

Investors focused on the long term must own companies that produce rising cash flow year after year, as we know stock prices will ultimately follow suit. Home Depot has done just that, warranting its current P/E ratio of 27. I’d pay up for a high-quality name like this, especially since management has been so generous returning cash to shareholders.

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Neil Patel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Home Depot and recommends the following options: long January 2021 $120 calls on Home Depot and short January 2021 $210 calls on Home Depot. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.