Costco Wholesale Corporation (NASDAQ:COST) stock has historically been a Wall Street darling due to its multiple qualities that differentiate it from its industry peers. For this reason, its shares have historically traded at a premium valuation, a theme that has held true through multiple market cycles.
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In my opinion, Costco exhibits many compelling qualities that distinguish it from other discount retailers. The company boasts an exceptional track record, a fabulous business model centered around membership, and promising prospects for international expansion, all of which undoubtedly deserve heightened recognition from investors.
That said, I believe that Costco’s above-average valuation could end up being a headwind for the stock’s total returns from here. With virtually all of the company’s competitors trading at considerably cheaper valuations and offering substantially higher capital returns, Costco’s overvaluation could hinder its investment case. Accordingly, I am neutral on the stock.
Costco’s Premium Valuation: Where Does It Stem From?
To put Costco’s premium valuation into context, I list the company’s and its peers’ forward P/Es in descending order below:
- Costco’s forward P/E: 34.9
- Walmart’s (NYSE:WMT) forward P/E: 24.4
- Dollar Tree’s (NASDAQ:DLTR) forward P/E: 23.5
- Dollar General’s (NYSE:DG) forward P/E: 16.5
- BJ’s Wholesale Club’s (NYSE:BJ) forward P/E: 16.1
- Target Corporation’s (NYSE:TGT) forward P/E: 15.3
Clearly, Costco stands out as the highest-valued stock in the industry, surpassing Walmart, which holds the second-highest forward price-to-earnings ratio among its peers, by a substantial margin. As a fun fact, it is worth mentioning that Costco has consistently maintained a higher forward P/E than all the aforementioned companies for over a decade.
Anyhow, I believe that the stock’s overvaluation can be attributed to several factors, the most prominent of which I have distinguished below.
A Flawless Track Record: The most prominent distinguishing factor that sets Costco apart from its peers, in my view, is the company’s impeccable track record. With the exception of 2009, when Costco experienced a marginal decrease in revenues, the company has consistently achieved revenue growth every year since 1992, which is the furthest back I have access to their public data.
Costco has also never posted an unprofitable year since that time. Further, despite the company being very mature, the pace of its growth continues to be quite impressive. Specifically, Costco’s revenues and net income have grown at a compound annual growth rate (CAGR) of 8.6% and 13.1% over the past decade, respectively.
Membership Model Boosts Predictability: Another prominent distinctive factor Costco possesses is its membership-based business model. Costco charges an annual membership fee, which provides exclusive access to its warehouses and online platform.
This model creates a strong customer-retention mechanism, as members are incentivized to continue shopping at Costco to maximize their membership benefits. In fact, Costco’s predictable revenue stream contributes to the company’s stability and long-term profitability, which is a very appealing characteristic for investors.
Replication of Business Model Internationally: The third factor that I believe contributes to the stock retaining a hefty valuation is the ample growth potential Costco has, which can be achieved by replicating its industry-leading business model internationally.
Costco’s successful international expansion so far, particularly in countries like Canada, Mexico, Japan, and the United Kingdom, has demonstrated its ability to adapt to different markets and capitalize on global opportunities.
However, the opportunities haven’t stopped here. There are multiple markets to expand to. A prime example is China, where Costco’s journey commenced as recently as 2019 with the opening of its inaugural physical store. The Chinese market warmly embraced the company’s warehouses, fostering a promising environment for extensive expansion throughout the country.
Lack of Substantial Capital Returns Exposes Overvaluation
The reasons mentioned above, along with other catalysts, partially explain why shares of Costco trade at a premium. That said, this doesn’t imply that the stock’s current valuation is entirely justified. In fact, I would argue that Costco’s lack of substantial capital returns exposes its overvaluation.
Take the two most established companies in the discount retail space — Walmart and Target. Both companies feature legendary capital return track records, boasting 50 and 55 years of consecutive annual dividend increases, respectively. Presently, Walmart offers a modest dividend yield of 1.5%, while Target boasts an attractive yield of 3.3%. In comparison, Costco’s current dividend yield is a meager 0.8%, nearly half of Walmart’s already modest yield.
Costco’s 0.8% dividend yield in the prevailing interest rates environment is merely cosmetic, failing to provide any substantial benefit. Additionally, the stock’s exorbitant valuation imposes severe limitations on alternative means of capital returns, like share buybacks.
The potential consequences of Costco’s high-priced shares make repurchasing them dangerous, potentially deteriorating shareholder value. This is evident by the fact that Costco’s repurchases haven’t surpassed the $1 billion threshold in any year over the past decade, with any buybacks amounting to fractions of the company’s total market cap.
What is the Price Target for COST Stock?
Turning to Wall Street, Costco stock has a Strong Buy rating based on 18 Buys and five Hold ratings assigned in the past three months. The average COST stock price target of $562.55 implies 3.1% upside potential.
If you’re wondering which analyst you should follow if you want to buy and sell COST stock, the most accurate analyst covering the stock (on a one-year timeframe) is Laura Champine from Loop Capital Markets, with an average return of 20.47% per rating and a 94% success rate.
The Takeaway
Overall, while Costco undoubtedly possesses numerous compelling qualities that distinguish it from its industry peers, its way-above-average valuation poses a challenge for potential investors, which can hurt its total returns, going forward.
Comparisons with competitors like Walmart and Target, which offer higher dividend yields and have a long history of capital returns, highlight Costco’s lack of substantial capital returns as well. Therefore, maintaining a neutral stance on the stock seems reasonable, in my view.
