Taiwanese investors have an inexplicable fondness for Costco. Going to Costco has become a national sport and they invest crazily in Costco stocks.
Preface
Before discussion of Costco’s valuation, as a reminder, it’s best to read my other two previous posts about Costco before reading this article:
Costco (ticker: COST) has been one of the better-performing non-tech stocks in the US stock market in the past few years. The warehouse retailer has thrived through all phases of the pandemic and its aftermath, first by handling record traffic as shoppers stocked up on essentials, and then by posting stunning sales growth as revenue soared. Costco has also experienced less growth hangover than its peers in the post-lockdown period.
Three facts to remember
Amazing business model
The first step for investors to understand a listed company is to understand its business model. This is a bit tricky for Costco investors.
Costco has about 600 warehouse stores in the United States and nearly 900 worldwide. These stores sell food, electronics, appliances, and more. With annual net sales of more than $200 billion, one might think that’s its business, just like other retail chains, but it’s not as simple as you think.
In fact, from a general business operations perspective, Costco’s retail business can barely break even because it tries to provide low-priced goods to please its members rather than increase the company’s profits. As the main consideration───this subverts the logic of business operations and the fundamental way of corporate survival. It seems unreasonable, but Costco has done it and done it well. That’s why the company goes to great lengths to keep the price of its famous hot dog combo at $1.50, for example. This is about getting customers what they want as cheaply as possible.
However, the Costco shopping experience isn’t for everyone—it’s only open to paying members. That’s the company’s real business: selling memberships. Those memberships account for about three-quarters of its profits. Therefore, it is imperative for Costco shareholders to monitor membership growth and renewal rates.
Growth opportunities remain huge
Costco expects to open 31 net new stores in fiscal 2024, which begins in September 2023, compared with just 23 in fiscal 2023. That’s a pretty modest single-digit growth rate. Still, management said on the earnings call that new U.S. store openings still accounted for more than 50% of new store openings, exceeding current expectations.
Encouragingly, Costco is seeing more domestic business opportunities than expected. Additionally, the company remains focused on international expansion. For example, it is about to open its sixth store in China–no one doubts that China’s huge market can open more stores in the future.
Costco has a consistent and reliable business model in a fairly familiar retail industry. If you factor in its growing e-commerce sales and its expansion both stateside and internationally, you’ll see there’s plenty of room for growth ahead.
The stock price is too amazing
Costco has a great business model and still has opportunities to grow. But the most important thing investors need to know is that “Costco stock is not cheap at all.” In fact, from a price-to-earnings perspective, Costco stock is trading at the most expensive price in more than 20 years, at a premium of about 70% to its 20-year average premium.
The late great Charlie. Charlie Munger loved Costco’s business, and it was one of only three stocks he directly owned (see my post “Charlie Munger, the Great Investor Worth Remembering” for details) ), despite being a well-known value investor. Therefore, he is willing to own a stock with a high valuation because of its good quality. This is something to remember. But as he once lamented to CNBC, “The problem with Costco is that it trades at 40 times earnings.”
Unrivaled competitiveness
Customer Loyalty
Everything starts from the customer’s perspective to gain customer loyalty. As of the third quarter of 2023 as of May 7, for example, Costco’s membership fee revenue exceeded US$1.4 billion, accounting for nearly 2% of sales. This is up from $984 million in the third quarter of 2022, which represented 1.9% of sales. Costco also announced a membership renewal rate of 92.6% in the United States and Canada and a global membership renewal rate of 90.5%, both tied with the renewal rate in the second quarter of 2023.
The number of new members is also increasing, with 69.1 million paying family members and 124.7 million cardholders at the end of the third quarter of 2023, both up 7% from the same period last year. That includes 31.3 million paying members and its more expensive corporate cards, accounting for 45% of total members and 73% of global sales.
Attractive product prices
Costco appears to have become a favorite and frequented shopping destination for its growing membership base. So it’s highly likely that it will continue to set new sales and profit records going forward, regardless of the consumer spending environment.
Branded advantages
These victories highlight Costco’s valuable competitive assets. It relies on low product prices, excellent service, and customer loyalty to build Costco’s powerful, priceless brand advantage that is difficult for competitors to imitate.
Continued good performance
Although Costco’s sales are unlikely to have a double-digit percentage growth rate due to the law of large numbers, it is one of the very few U.S.-listed retail companies willing to announce its sales performance every month. This fully proves that Costco is very confident in its business performance, and it indeed shows that it has this ability.
Despite recent market concerns about weakening financial health of U.S. consumers, Costco tends to be more resilient during economic downturns due to its membership model and the fact that it serves many higher-income customers.
Profit comes from members fee
This is not only one of the anomalies among the companies listed on the US stock market, but it is probably rare in the world that can survive only relying on the annual membership fees paid by customers, and can also operate the company in a sound and impressive manner, causing all walks of life to A very small number of companies are competing to imitate its successful model.
Costco is a retailer, which means investors will want to focus on comparable store sales for signs that the business is on track. However, I will stress again that Costco’s long-term returns are closely tied to its membership metrics. Because the business makes most of its revenue from members: membership fees account for about three-quarters of its profits. Importantly, its renewal rates continue to climb to record levels.
In 2023, Costco renewed memberships in 93% of its members in its core U.S. market. This number confirms that Costco is providing a lot of value to its members, and its bottom line is likely to continue to climb steadily. Costco’s fiscal 2023 operating profit was $8.1 billion, compared with $4.7 billion in 2019.
Capital market performance
Disadvantages of its stock
However, there are a few factors that could weigh on the stock in the coming years. Wall Street is excited about the upcoming membership fee hike, but may be disappointed to see the hike translate into only modest earnings growth.
It’s been more than five years since it last raised annual membership fees, and by many accounts, Costco should. But management prefers to use almost all the extra cash generated by government stimulus measures to lower prices rather than improve profitability.
On the bright side, this approach means shareholders don’t have to endure the year-to-year earnings swings that are common at retailers like Target Stores (ticker: TGT ). The downside is that even in good times, Costco’s profit margins tend to remain low, around 3% of sales.
Investors may also be disappointed with the chain’s cash returns over the next few years. Rather than committing to generous annual dividends like Walmart (ticker: WMT) , Costco returns most of its cash to investors in unpredictable, sporadic payments.
Price vs. value
The big question is whether this success will lead to market-beating returns for patient investors. Unfortunately, its stock is expensive. Costco stock is valued at 1.3 times annual sales, its highest premium in the past decade.
You could buy Target at 0.6x sales, or Wal-Mart at 0.7x revenue. Amazon (US: AMZN ) also appears to be worth a relative value of 3x sales, given rising profitability and lots of potential for growth.
Since it’s outperforming its retail peers, with growth and stable cash flow clearly ahead of its competitors, Costco stock should still perform well compared to its retail peers. But given the stock’s current expensive valuation, investors should temper their expectations for short-term returns.
Valuation
The price-to-earnings ratio can provide investors with a good gauge to determine whether valuations are indeed accelerating too quickly. The stock has traded at an average price-to-earnings ratio of less than 56 times over the past decade. Today, the stock trades at a price-to-earnings ratio of more than 49 times. Investors are paying a huge price-to-earnings ratio for the stock.
Costco’s valuation has always been higher than that of most high-tech stocks. This is one of the many miracles on Wall Street, and this phenomenon has existed for a very long time. If there are no accidents, it will continue to happen again in the foreseeable future. continued.
In Costco’s long history as a public company, its trailing-12-month P/E ratio has never been as high as it has recently.
All I can say is, don’t use ordinary retail or general industries to explain its valuation. Costco’s valuation phenomenon in the retail industry should be comparable only to Amazon.
Share price return
The following is the return on the stock price of Costco and its competitors over the past one and five years as of February 16, 2024, as well as other important stock price valuation figures.
| Stock | Share Price | Return in past 5 years | Return in past 1 year | P/E | Dividend Yield | Market Capitalization (US$ billion) |
| Costco | 723.99 | 234.71% | 44.30% | 49.37 | 0.56% | 321.25 |
| Target | 149.61 | 107.07% | -9.99% | 19.06 | 2.94% | 69.07 |
| Walmart | 170.36 | 71.13% | 15.63% | 28.28 | 1.34% | 458.65 |
| Amazon.com | 169.51 | 107.78% | 79.22% | 58.46 | 0% | 1,760 |
| S&P 500 | 5005.57 | 79.24% | 25.22% | 23.27 | 1.47% | 40,040.00 |
Is the premium too high?
High P/E multiples are not uncommon for rapidly growing companies. But the crux of the matter is that Costco’s growth rate has slowed significantly in recent years, and it is below its 10-year average. Generally speaking, when revenue growth exceeds 20%, it’s probably acceptable to think that premiums for retail stocks are likely to be higher.
There’s only one possible explanation for Costco’s current apparently high and unreasonably high stock price valuation: Investors clearly believe this is the exception, not the norm, for Costco.
Conclusion
Costco is doing great business. It plans to open more stores, its membership prices may soon rise again, and there’s little concern that the business has exhausted its growth opportunities. Costco may be a good long-term buying opportunity, but at its current price-to-earnings ratio, investors are paying a lot for future earnings growth.
If you want to stick with it for decades, it’s still a good investment for you. But it’s not a stock I would buy today, simply because there are better deals on the market today and the potential for greater upside in the near future.
I would consider investing in Costco if it traded below 40x P/E, but at today’s valuation it’s increasingly difficult to justify the price. While Costco isn’t necessarily a bad investment, there are better long-term options for investors. After all, this isn’t the growth opportunity that it was in the 1980s.
That said, I’m waiting for a a better share price.
I am the author of the original text, the essence of this story was originally featured on Smart Magazine
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