Dueling Fools: Costco Bear

It's been several months since I last dueled for the Fool, so forgive me if I'm a bit rusty at this. Today, I've accepted the glove thrown down by my estimable opponent, Tim Otte, to debate the merits of Costco Wholesale (NASDAQ:COST).

But the thing is, the more I look at this company's stats, the more confused I get. Costco's a warehouse wholesaler, right? And isn't the whole idea behind such companies that they're supposed to be cheap?

The goods, not the stock
Ah, yes. Well, I suppose that's the thing. The wares in Costco's warehouse superstores may be cheap, but the stock is anything but.

Now, I could at this point use my go-to metric for gauging a company's valuation: price to free cash flow. But I won't do that, and for two reasons. First, it would scare the pants off you, the reader. And if you're reading this surreptitiously in an office somewhere, that could prove embarrassing. Second and more importantly, I won't tell you about Costco's 100-plus price-to-free cash flow ratio because the metric isn't terribly useful when evaluating a firm like this one, which plows the bulk of its operating cash flow into capital expenditures (decreasing free cash flow in consequence).

As fellow Fool Ryan Fuhrmann pointed out in his own duel over Costco some seven months ago, a company like Costco, which spends a lot on building out its store base (it's added 33 new stores over the last year, and 25 more in the 12 months before that), necessitates breaking capital expenditures down into "maintenance" and "expansion" capex parts. Rather than reinvent the wheel to calculate these numbers, I'll limit myself to quoting Ryan's observation that "free cash flow is very similar to [GAAP] earnings for Costco." Meaning that we can do without the cash flow analysis, and take the firm's plain-vanilla P/E ratio as a decent proxy when figuring valuation.

Price check on vanilla
So what's the P/E picture look like? Costco currently trades for 24 times trailing earnings, versus long-term profits growth that analysts project at 13% per year. Result: The firm carries a PEG ratio of 1.8.

For comparison, the broader "market" -- the S&P 500 -- trades at an already historically high 18.5 P/E, yet carries nearly the same implied growth rate that Wall Street attributes to Costco: 12.6%. Result: Costco is trading at about a 20% premium to the market. The question, then, is whether Costco is worth that premium. Judging from the numbers, I'd have to answer: "No, it isn't."

With the sole exception of warehouse wholesaling also-ran BJ's -- which lags the pack by just about every metric conceivable (overpriced, slow-growing, and not terribly good at earning profits on sales) -- Costco looks to me like the least attractive stock in big-box land. Its P/E isn't just expensive when compared to the broader market, but also when compared to its peers. Yet Costco's growth rate is no better than average, and it's actually slower than either Target's or Best Buy's. Finally, Costco is only about half as profitable as those peers.

Pay more, get less
Being familiar with Tim's past writings on Costco, I think I can predict his bullish thesis on Costco. It will run something along the lines of "you need to pay up for quality." Problem is, Costco doesn't have the quality. And you don't need to pay as much for the companies that do.

You're not done yet! If you missed the bull's argument, it's here. If you've already read everything, cast your vote for the winner here. 

Costco and Best Buy are Motley Fool Stock Advisor selections. Wal-Mart is a Motley Fool Inside Value recommendation.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. If he did (or was), The Motley Fool would require him to tell you so. We're sticklers about things like that.