In the Dueling Fools Bull opener, fellow Fool Alyce Lomax sums up well why Costco (Nasdaq: COST ) has been such a powerhouse of a company and one of the better stock selections investors have made in recent years: "Costco seeks to build a good, solid, dependable business, with the idea that that is exactly what will reward shareholders over the long haul. And what more could long-term investors want?"
I agree completely. The problem is, Costco is not longer the well-kept secret it used to be. So while current shareholders have been treated well, now that the cat is out of the bag, what does the future hold for investors not already in the stock? It all comes down to margin of safety.
As I detailed in my bearish introduction, I think Costco is fairly valued right now. It's grown in the double digits for as long as anyone can remember, and as far as I can tell, the market is projecting it to grow for about 11% for the next decade and then grow at the same rate as the overall economy, or no more than a couple of percent per year.
Or maybe Costco will grow even faster for another few years before it becomes more mature and growth slows. Alyce mentioned that growth expectations for Costco range from 12% to 17% over the next three years. Whether Costco grows at the high or low end of that range will decide whether the stock is worth buying right now.
If Costco grows 12% a year for the next three years and growth gradually declines to that of the overall economy over the next decade, then the stock is slightly overvalued. But if Costco grows 17% and then slows for the next 10 years, it is as much as 25% undervalued right now. As you can see, compounding growth is the key for any successful investment.
To answer Alyce's question, to rate Costco a buy at current levels, it needs to either grow in the double digits for at least another decade or close to 20% a year for the next few years, assuming my initial starting point for free cash flow is reasonable. It's definitely doable, based on management's track record in building an enviable company that treats all stakeholders well.
But it won't be easy. Wal-Mart (NYSE: WMT ) is focusing on Costco's archrival Sam's Club to help it offset slowing growth in its namesake stores, and there has been past mention that it may pursue spirited beverages for future category killers. Other big-box retailers keep the space ultra-competitive, with Target (NYSE: TGT ) hitting the low-cost trendy end and Best Buy (NYSE: BBY ) and Circuit City (NYSE: CC ) squeezing margins in consumer electronics. And Alyce mentioned that Amazon (Nasdaq: AMZN ) is using cyberspace as a cost advantage to peddle any and all types of merchandise.
So how big is the margin of safety in case the competition catches up to Costco or expansion and growth expectations don't turn out according to plan? Not very big, in my opinion. Fellow Fool Tim Beyers, recently offering his take on margin of safety, said that a stock that trades close to its intrinsic value offers virtually no margin of safety. In other words, to beat the market, one has to look for dollar bills trading at 50 to 60 cents to stand a chance that it will eventually trade up to its true worth. In Costco's case, I surmise that investors are paying closer to 90 cents, or very close to a full dollar of fair value. I could be proved wrong, but I would rather patiently wait for a better bargain down the road.
To sum it up, we have a clear-cut case of amazing company, not-so-amazing stock.
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Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.