In 10 Years, You'll Wish You Bought More of This No-Brainer Stock

It isn’t a great time to be a homebuilder. Rising interest rates are pricing buyers out of the market, and materials inflation is running wild. And other home sellers are still on the market with FOMO on generationally high prices.

The market is well aware. Most homebuilders are trading for single-digit P/Es, with some as low as three or four. This may be nauseating to some investors, but for value investors, it’s the perfect environment. As Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful.”

Toll Brothers (TOL -0.97%) is a luxury homebuilder. It has unique advantages in a rising rate environment but has still fallen over 30% this year. Let’s talk about how the company is insulated from housing market fears and what level of risk is already priced into the stock.

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Interest rate immunity

Most homebuilders are directly affected by increased interest rates. Homebuyers can no longer afford as their ideal home size, and builders are seeing decreased demand for spec homes that are already done, lots that haven’t been developed, and their work in progress.

This is evidenced by the drop in new housing starts over the past two months. In April, construction began on about 1.8 million new houses. By June, that number was down to 1.56 million, according to the U.S. Census Bureau.

Toll Brothers has some level of immunity to interest rate risk because of the clientele it serves: 20% of its buyers pay with cash and have no interest rate sensitivity. Its remaining customers have an average loan-to-value of 70% and are required to use jumbo loans. Many lenders are still doing jumbo loans at rates below 4.50%. Additionally, the company currently has close to 12,000 (just over a year’s worth of work) houses in its backlog to be built.

As far as inflation risk, the company has a few levers to pull. In addition to the 12,000 houses in its backlog, it owns or controls another 70,000 lots where the land price has already been locked in. Much of its build costs are subcontracted out on fixed-price contracts, and it locks in material prices for a year, which is around how long it takes to build a typical home. Its main inflation risk is that new buyers will be priced out of the market — this is certainly a risk, but to a lower extent with Toll Brothers’ affluent customer base.

Valuation

The stock is definitely undervalued at first glance. The P/E of 6.13 is well below the five-year average of 10.86 and is still low if you adjust it for cyclicality. Additionally, the forward P/E is just 8.92, which is barely more than half the S&P 500 level of 16.95.

The price to earnings ratio isn’t perfect, but anything in single digits signals that the stock is probably significantly undervalued. It’s also important that adjusting the P/E to use analyst estimates of future earnings (the forward p/e) still shows a single digit number, even though analysts expect earnings to drop. The market clearly thinks that the business is due for a down cycle.   

However, that cycle isn’t here just yet. The business is still growing at every level of the income statement. In the second quarter, it finished 2,407 new houses and had $2.2 billion in revenue, both more than it had ever done before. It grew EPS by 83% from the same quarter in 2021 thanks to a 1.7% increase in its gross margin. Gross margin is what’s left of sales after direct cost of goods sold. That increase is important because it shows that the business is using its pricing power and increasing prices more than inflation is affecting its direct costs.

Additionally, it signed $3.1 billion in new contracts despite limiting sales at 50% of its locations. As of May 24, management still projected year-end revenue growth of 20% and a 2.5% increase in gross margin for the year. That’s a lot of room for error if the housing market really does collapse.

If the stock price just reverted to its five-year P/E mean of 10.86, that would be a gain of 77%. So how does it get there?

The first step is to keep performing, and we’re well on the way to that. Management could also buy back stock or increase the dividend yield. Indeed, $900 million in stock buybacks are already authorized. Right now, net cash is down to around $535 million, thanks to around a $1 billion in inventory purchases since October 2021. As it develops that inventory and starts churning out cash flow, it could use that cash to buy back shares.

Buying single-digit P/E stocks is stressful. There is usually a good reason for the market’s hesitance, but digging deeper and forming a variant opinion can be the way to outsized returns. In this case, Toll Brothers is down along with every other home builder despite the fact that it has legitimate business model differences that should protect its business even if housing prices really do collapse over the second half of 2022. 

Mike Price has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.