Is Costco the Perfect Stock?

Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everything you could possibly want?

One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide if Costco Wholesale (Nasdaq: COST  ) fits the bill.

The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.

Some of the most basic yet important things to look for in a stock are:
 

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
  • Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
  • Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
  • Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Costco.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-Year Annual Revenue Growth > 15% 8.0% fail
  1-Year Revenue Growth > 12% 9.1% fail
Margins Gross Margin > 35% 12.8% fail
  Net Margin > 15% 1.7% fail
Balance Sheet Debt to Equity < 50% 21.6% pass
  Current Ratio > 1.3 1.16 fail 
Opportunities Return on Equity > 15% 12.5% fail
Valuation Normalized P/E < 20 22.66 fail
Dividends Current Yield > 2% 1.3% fail
  5-Year Dividend Growth > 10% 12.4% pass
       
  Total Score   2 out of 10

Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.

With a score of 2, you'd think Costco was a stock to avoid. Yet a closer look points more toward limitations of the perfect stock model rather than problems with Costco in particular.

For one thing, growth for mature retail businesses is very hard to come by. Both Target (NYSE: TGT  ) and Wal-Mart (NYSE: WMT  ) have seen slower revenue growth than Costco, both in the past year and since 2005. Moreover, in an industry that's already famous for its low margins, Costco cuts its margins even thinner, just beating out BJ's Wholesale (NYSE: BJ  ) .

In order to juice returns on equity, other retailers such as Target and Wal-Mart take on much greater levels of debt. And although its low current ratio may look troubling, Costco actually manages its accounts payable to maintain a negative cash conversion cycle, delaying payments long enough to completely offset the costs of maintaining its inventory.

Reflecting its premium status within retail, Costco trades at a fairly rich multiple. Where Costco can best improve its standing is in its dividend policy; the company pays out only about a quarter of its income, and despite Costco's strong dividend growth rate, it could easily support a yield of 2% or more without jeopardizing its financial status.

Costco provides a great example of a company where you have to look beyond the numbers to understand its context within its industry. Once you connect the dots, Costco looks a lot closer to perfect.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Click here to add Costco to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. Costco is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Costco and Wal-Mart, which are both Motley Fool Inside Value picks. Try any of our Foolish newsletters today, free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


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