The entire real estate industry is down this year and home builders have taken as big of a hit as any industry. Many of the most successful home builders are trading at single-digit price-to-earnings (P/E) ratios, and some are even trading for a P/E of less than 5. Normally, a P/E below 10 would be a strong buy signal for value investors.
But there’s one problem.
Home builders are traditionally cyclical stocks. During expansions, when interest rates are low and home buying is rising, they make a lot of money and have higher earnings. When the cycle turns, like it has over the past few months, earnings go way down. It’s possible that the market is just anticipating bad earnings in the future and home builders are a value trap.
Today, I want to look at Lennar (LEN -0.52%), Toll Brothers (TOL -0.12%), and Meritage Homes (MTH -0.88%). We’ll adjust the P/E of each to try to decide if they’re really a value, or just a value trap.
Lennar is more diversified than most home builders. In addition to building homes, it has a real estate tech subsidiary, and it builds and leases multifamily apartment buildings. Those two divisions should be spun off by the end of the year, allowing management to focus on its core home building business.
Lennar currently has a P/E of 5.4 and dividend yield of 1.9%. The current S&P 500 P/E is 19.7 — so at first glance, Lennar looks deeply undervalued.
The first way we’ll measure whether Lennar is truly undervalued, or if its ratio is low based on high cycle earnings, is with the cyclically adjusted price-to-earnings ratio (CAPE). The CAPE uses a 10-year average of earnings for the denominator in the ratio to smooth out economic cycles.
Lennar’s current CAPE is about 15, substantially higher than its P/E, but that’s to be expected. Lennar’s earnings per share (EPS) in 2021, at the peak of a cycle, was $14.21; in 2017 it was just $3.38. Both years get equal weighing in the CAPE so that we can compare the current stock price to a full cycle’s worth of earnings.
The current S&P 500 CAPE is 28.9. That’s still higher than Lennar, but not quite the almost four times higher than the standard P/E. Next, we’ll look at forward P/E.
Where the CAPE looks backward and the P/E looks at the most recent year, forward P/E is based on analyst estimates of earnings for next year. If analysts expect the business to dip in a down cycle, the forward P/E should be higher. Lennar’s forward P/E is 4.7 — this means analysts expect Lennar to make more money next year than it did this year.
The current forward S&P 500 P/E is 16.7. Again, it’s much higher than Lennar, but not by quite the same margin as the straight-up P/E.
Toll Brothers differentiates itself by building luxury homes, selling to people who don’t need mortgages at all or don’t need as much mortgage. Twenty percent of its buyers pay cash and the rest average a loan-to-value of 70%, meaning they put 30% down.
Toll Brothers shouldn’t have been hit as hard as other homebuilders because of this advantage, but its stock is still down more than 30% year to date and it trades for a P/E of about 6. Let’s look at our other two metrics.
Toll’s CAPE comes in at 15.6. It also had a peak year in 2021, with earnings per share (EPS) of $6.63. But the past five years have been smoother for Toll Brothers, and its EPS was never lower than $3.17 over that time frame.
The forward P/E for Toll is 4.4, again surprisingly lower than the current P/E. That indicates research analysts think that both of these home builders will continue to increase earnings.
Meritage is the opposite of Toll Brothers; it focuses on entry-level homes. You’d think that means it wouldn’t do well in a downturn because entry-level buyers will have to keep renting. But according to management, entry-level buying stays consistent in downturns and when interest rates rise because buyers who are looking a tier up shift down to entry level.
Meritage’s P/E is the lowest of the three, just 3.8. Its CAPE is 13.2 and the forward P/E is 3.2.
Value or value trap?
Home builders will be the talk of value town for the next few years with P/Es this low. Some value hedge fund managers are already all-in. Each of the three home builders we looked at was undervalued in straight-up analysis and when adjusted for cyclicality. The next step is to do further analysis to determine whether net income will stay strong, as analysts believe, or whether these home builders are in for a few bad years.