Toll Brothers Inc. (TOL Quick QuoteTOL - Free Report) shares have been performing remarkably well, trading close to their 52-week high of $154.62. Over the past four trading days, the stock has hovered around $154 per share, finishing at $150.62 on Thursday, just below the 52-week peak reached on Sept. 18.

This luxury homebuilder, based in Horsham, PA, has seen its stock surge 30.7% over the last three months, outperforming the Zacks Building Products - Home Builders industry’s 25.6% rise. During the same period, the sector has increased 16.2%, while the S&P 500 gained 4.3%.

Toll Brothers benefited from operational efficiencies, strong demand across various regions, and a growing inventory of speculative homes. The company is well-positioned to take advantage of long-term demographic trends and the ongoing housing supply shortage. With the Federal Reserve’s recent 50 basis point rate cut likely to push mortgage rates even lower, demand for new homes may see an additional boost.

Three-Months Performance

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The stock is currently trading above both its 50-day and 200-day moving averages, as shown in the chart below, indicating strong investor confidence and a favorable market outlook.
 

Image Source: Zacks Investment Research

This upward momentum raises an important question for investors: Is Toll Brothers still a good investment at these highs?

Knowing the Driving Factors of Toll Brothers

Balanced Operating Model: Toll Brothers has strategically set a target for about 50% of its homebuilding business to come from speculative (spec) homes and 50% from build-to-order (BTO) homes to fuel growth. The company adjusts its approach based on current market conditions. This strategy allows Toll Brothers to respond effectively to changes in demand, especially in a fluctuating economic environment.

Toll Brothers increased its inventory of spec homes, which represented 54% of orders and 49% of deliveries in the third quarter of fiscal 2024, catering to buyers seeking quicker move-ins. This reflects a deliberate move to increase the proportion of spec homes in their overall mix.

As mortgage rates come down following the Fed’s recent rate cut, the demand for spec homes is likely to increase further. Lower financing costs could attract more buyers looking for immediate occupancy, enhancing the attractiveness of Toll Brothers’ spec home inventory.

Favorable Demographics: A major driver of Toll Brothers’ success is the millennial demographic, which is increasingly entering the housing market. Many millennials are buying their first homes later in life, often in their 30s and 40s, after accumulating wealth and higher incomes. This trend is driving demand for luxury move-up homes, a core segment for Toll Brothers.

Again, older millennials, many of whom are now in their 40s, are becoming key customers for Toll Brothers’ luxury housing products. Baby boomers, another critical demographic, are also contributing to the demand. Many of them are purchasing new homes as they retire or downsize, looking for properties that cater to their changing lifestyles. Toll Brothers has strategically positioned itself to cater to this market segment through luxury offerings.

Land Positioning: Toll Brothers’ land portfolio remains a key driver for growth. The company ended the fiscal third quarter with 72,700 owned or controlled lots, providing ample inventory for future growth. Approximately 55% of these lots are controlled through option agreements, which gives the company capital efficiency by deferring payments and reducing upfront capital requirements.

The company plans to continue growing its community count, aiming for 11% growth by the fiscal year-end. This strategic expansion is supported by the land pipeline and ensures that Toll Brothers can meet demand in both existing and new markets.

Product and Price Diversification: Toll Brothers has continued to diversify its product offerings by expanding into more affordable luxury homes. This has helped the company capture a wider range of buyers and reduce reliance on higher-end buyers who may be more affected by interest rate volatility.

The company now operates in 60 markets across the United States, offering homes ranging from the mid-$300,000s to over $5 million. This wide range of price points allows Toll Brothers to better manage fluctuations in market conditions while still attracting high-income buyers.

TOL's Estimate Movement & Valuation

Analysts have revised earnings estimates upward, further solidifying Toll Brothers' position as an attractive stock.
 

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Toll Brothers is trading at a discount relative to the industry it belongs to, as shown in the chart below. It is also trading at a discount compared with the big industry players like D.R. Horton, Inc. (DHI Quick QuoteDHI - Free Report) , Lennar Corporation (LEN Quick QuoteLEN - Free Report) and NVR, inc. (NVR Quick QuoteNVR - Free Report) . Despite the stock’s outperformance, TOL’s current valuation is still considered undervalued. This might suggest that the market has not yet fully recognized or priced the company's potential growth prospects or earnings potential. Presently, TOL holds a Value Score of B.

Image Source: Zacks Investment Research

What May Pull Back Toll Brothers?

The homebuilding industry, including Toll Brothers, continues to face challenges due to rising labor and material costs. Despite efforts to streamline operations and enhance efficiency, these escalating costs remain a significant obstacle for the company.

Additionally, a drop in consumer confidence in August, driven by concerns over job security and business conditions, has created a difficult environment.

A key factor affecting Toll Brothers' profit margins is the higher proportion of spec homes in its sales portfolio. While spec homes offer faster sales and improved cash flow, they typically yield lower margins compared to BTO homes.

The company’s use of incentives and discounts also pressures gross margins, especially when applied broadly. In the case of Toll Brothers, incentives on spec homes are often larger because these homes need to sell quickly to minimize prolonged construction and holding costs.

One such incentive is the use of rate buydowns, which allow buyers to temporarily secure lower mortgage rates. While this strategy can help stimulate sales, it also has a negative impact on margins.

For the recent quarter, Toll Brothers reported an adjusted home sales gross margin of 28.8%, reflecting a 50 basis-point decline. Selling, general, and administrative (SG&A) expenses represented 9% of home sales revenues, up 40 basis points compared to the same quarter last year.

What Should Investors Do Now?

The Federal Reserve's latest rate cut will give a boost to the demand scenario of Toll Brothers and other industry players in the homebuilding industry.

This week, the average rate on a 30-year fixed-rate mortgage remained stable but dropped to its lowest level in two years. According to Freddie Mac data, 30-year mortgage rates averaged 6.08% as of Thursday, slightly down from 6.09% the previous week. With rates trending downward, refinancing activity is on the rise, offering homeowners the opportunity to reduce their monthly mortgage payments.

While lower mortgage rates, favorable demographics, a strong customer base, positive earnings revisions, attractive valuation, and stock outperformance present a favorable outlook for Toll Brothers, caution is warranted. Rising costs, fluctuations in consumer sentiment, and margin pressures could pose challenges.

Current stakeholders are advised to maintain their position in this Zacks Rank #3 (Hold) stock. At the same time, potential new investors might consider waiting for more clarity on how Toll Brothers navigates these challenges before making investment decisions. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.