Costco (NASDAQ: COST): A great company with a pricey stock
Warren Buffett says that when he looks for stocks to buy, he wants excellent companies selling at fair prices.
There are plenty of excellent companies out there, but it’s questionable whether many of them are fair priced. The market’s rising tide – a 57% gain for the S&P 500 over the past two years – has lifted most boats big-time.
One of the excellent companies riding the wave is Costco (NASDAQ: COST). Its stock has surged 107% during the last two years, almost double the S&P 500’s gain.
Most every analyst covering the niche retailer has a positive view of it. They note its ability to thrive in a cut-throat industry, with competitors such as Walmart (NYSE: WMT) and Amazon (NASDAQ: AMZN), where e-commerce plays a central role. Costco’s strong bond with its customers and low expenses help keep it humming.
But many experts think the stock is overpriced. Morningstar analyst Noah Rohr puts fair value for Costco at $560, more than 40% below its price of $943 Friday.
Costco’s strengths
All this raises the issue of what makes Costco a great company and what indicates that its stock is overvalued. In case you aren’t familiar with it, Costco charges a basic annual membership fee of $65. It sells a limited array of high-quality products in bulk quantities and at bargain prices – particularly food and groceries.
Its stores are warehouses, and it has 890 of them worldwide, with more than 600 in the US. Plenty of people are taken with Costco’s formula. It has 77 million members globally and a customer retention rate of 90%, despite membership price increases every five years or so.
Costco’s no-frills, high-quality, low-price model attracts plenty of wealthy people. A total of 36% of Costco shoppers have household income of $125,000 or more, according to data firm Numerator.
The company keeps its costs at a minimum. Its ratio of selling, general, and administrative expenses to revenue is 9% to 10%, about half the total of competitors, such as Walmart and Target, according to Rohr.
Costco’s same-store sales increased 5% to 6% in each of the past two years. Earnings per share gained 10% in the quarter ended in November from a year earlier.
Costco’s only direct competitor is Walmart’s Sam’s Club, which has a basic annual membership fee of $50. It has 600 stores in the US and Puerto Rico, along with a presence in China and Mexico. But Sam’s Club fiscal 2024 sales totaled almost two-thirds less than Costco.
Costco may be overvalued
On the downside, investors may have gotten carried away with Costco’s financial strength as they seek to join the raging bull market. Valuation is an issue.
Costco’s trailing price-earnings ratio is 56, far above its five-year average of 41 and Morningstar’s Total Market index current reading of 26. Costco’s forward PE ratio is 53, compared to 34 for Walmart, 14 for Target (NYSE: TGT) and 37 for Amazon.
Costco’s PE ratio also exceeds that of investor favorites Microsoft (NASDAQ: MSFT) and Nvidia (NASDAQ: NVDA), even though Costco’s sales are rising at a much slower rate than those titans.
Of course, you could argue that the best comparison for Costco is subscription-based companies, such as Netflix (NASDAQ: NFLX). And that company has a trailing PE ratio of 52, close to that of Costco. So perhaps the stock isn’t overvalued.
Nonetheless, it will be difficult for Costco to boost revenue much in percentage terms, as sales already total $250 billion a year, Bill Smead, manager of Smead Value fund, told Barron’s.
There’s nothing wrong with Costco. But before buying the stock, you may want to see confirmation of its strength in the next earnings report March 13.
