To understand why the public homebuilders have no business
trading at their current prices, one needs to look no further than
their price to earnings ((
)) ratio. As most public homebuilders haven't reached profitability
on a trailing twelve month basis for over two years, their current
price to earnings ratio has been incalculable and useless.
However, as these builders slowly make their way back to
positive earnings and exude excitement from unknowing investors
that believe they are buying at the bottom, it is important to look
at where we have been to help figure out where we might be
When profitable, most public homebuilders traded at similar PE
ratios. During the period from 2000 through 2006, arguably the
strongest period of growth in the housing industry, homebuilder PE
multiples were generally just below 10x on a Trailing Twelve Month
)) basis and 8x on a Forward Twelve Month ((
Assuming those multiples are the norm for the industry, how long
will it take these builders to get the earnings to catch up with
This is not likely to happen anytime soon.
Our approach started with the premise that homebuilders' stocks
should eventually get back to trading at historical PE multiples of
8x (on a FTM basis). We developed a simple financial model to
determine what improvements in home closings and average sales
prices need to occur in order for homebuilder's earnings to make
sense in light of current share prices.
We performed this analysis on the top publicly-traded
homebuilders ([[BZH]], [[DHI]], [[HOV]], [[KBH]], [[LEN]], [[MDC]],
[[MTH]], [[PHM]], [[RYL]], [[SPF]], [[TOL]]), but have chosen to
highlight two builders for this article, DR Horton (
) and KB Homes (
). While there are many variables that could be adjusted, the fact
is closings and the average sales prices are going to be the
primary drivers for homebuilder earnings improvement going
Most builders have already shaved their overhead as far as they
can. Therefore, inherent in our analysis is that selling, general
& administrative (SG&A) expenses will remain at current
levels going forward, and staffing levels and advertising, will be
adequate to handle the increase in volume (we know this is
conservative and borderline funny, however we had to start
The only portion of selling and marketing costs that we assumed
to be variable are commissions since they are directly tied to the
sale of a home. As a result, SG&A, which is currently running
in the high teens as a percentage of revenues for most homebuilders
today and actually higher for several others, with the exception of
DR Horton, should decline to approximately 10% of revenues in the
future. This is a pretty conservative level as only DR Horton would
consistently achieve an SG&A level of 10% of revenues in the
"good old days."
We also assumed that gross margins in the future will be in the
22-25% range, excluding the impact of impairments. Currently, when
you exclude impairments, the homebuilders, as a group, are selling
homes at approximately 16%.
Historically, builders that operated in the high growth areas of
California and Florida would expect to see margins in the high 20%
range, and those that operated in the lower growth regions would
expect to see gross margins in the high teens. On a blended
average, 20-25% has historically been a reasonable goal of most
Additionally, we assumed that financing would be available to
fund any additional growth. Further, as these results are expected
to happen a few years down the road, we assumed they would be tax
payers at a rate of 35%.
DR Horton would need to achieve a target EPS of $1.59, or $533
million of net income, assuming an 8x PE multiple based on their
approximate 318 million shares outstanding to support their current
stock price of $12.70. Given their current trailing 12 months of
closings and average sales price in backlog, DR Horton would need
to grow their revenues to $6.7 billion or approximately 70% from
today's current pace.
In order to hit this level, we assumed that they would need to
grow their unit closings by 50% and raise their average sales price
15%. If DR Horton could increase their average sales price 4% per
year and grow closings 15% per year, they would achieve an EPS of
$1.59 in just less than 4 years.
This also assumes that their SG&A which currently is at
14.4% of revenues would decline to 9.5% and their gross margin,
which is currently at 18%, would improve to 23%. As a point of
reference, DR Horton was running SG&A at 9-10% of revenues
during their peak earnings years.
KB Homes, would need to achieve a target EPS of $1.98, or $153
million in net income, assuming an 8x multiple based on their
approximate 77 million shares outstanding to support their current
stock price of $15.85. Given their current pace of home closings
and their average sales price in backlog contracts, KB Homes would
need to grow their revenues to $2.9 billion or approximately 80%
from today's pace.
In order to hit this level we assumed they would need to grow
their unit closings by 50% and raise their average sales price by
20%. If KB Homes could increase their average sales price by 4% per
year and grow closings 10% per year, they would achieve an EPS of
$1.98 in just over 4 years.
This also assumes that their SG&A would decline to 12.5%
from their current level of approximately 17% and their gross
margin, which is currently at 18.8%, would improve to 23%. As a
point of reference, KB Homes was running SG&A at 12-13% of
revenues during their peak earnings years.
Our assumption for the annual growth rate of closings for most
builders ranges from 10-15%. During the early 2000's, annual growth
rates for housing starts and new home sales ranged from 7-12%.
However, the economic climate was much more favorable during this
earlier time period. Further, most homebuilders are still showing
declines in unit closings, with only Beazer (
) and DR Horton producing YOY increases for their most recent
Our assumption for annual average sales price increases is 4%,
while many economists are predicting less than 4% annual increases
over the next four years. Actual growth in closings and sales price
appreciation will be impacted by the overhang of foreclosures and
shadow inventory which continues to depress the level of housing
starts and mortgage applications. As a result, we believe that 4
years appears to be a reasonably conservative estimate for DR
Horton, KB Homes and the other public builders to achieve a level
of earnings that would warrant trading at their current stock
The real issue isn't whether homebuilders will ever get back to
these earnings levels, but rather when will they. If that 'when' is
in 4 years, then why invest in these homebuilders at the current
price levels today?
How the Market Is Functioning Like a Sifting