Home Depot: A stock to stock up on?

— -- A: It hasn't been a big surprise to see how investors have punished shares of home builders and mortgage companies as the housing bubble burst.

That debacle has also infected other areas of the bond and stock market. Since July 2007, shares of Home Depot have come under intense pressure, falling from more than $40 to close to $23 the past 52 weeks. So while the Standard & Poor's 500 index has lost less than 10% the past year, Home Depot lost 25%.

When a big, brand-name company stock drops like that, investors start asking the question you pose: Is it a buying opportunity? To find out, we'll put the stock through the four tests we consider:

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Home Depot's trading history back to 1984, we see the company generated an average annual compound rate of return of 28.9%. That is outstanding if you consider the S&P 500 returned more than 10% annualized over the same time period.

But to beat the S&P 500, you accepted high risk — standard deviation — of 50.4 percentage points. That's 162% greater than S&P 500's risk during the same period.

Now, wait a second. Home Depot is one of the rare stocks where investors have been compensated for their higher risk with a proportionately higher return. One big caveat, though, is that most of the stock's big gains came early in its life, as it was rapidly opening stores and growing much more quickly than it does today.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs. When we run Home Depot's stock, we find it's rated "attractive." In other words, the current stock price is less than what the company is expected to generate in cash over it's lifetime. Using this analysis, it would appear Home Depot's stock may be worth a closer look.