Some businesses seem to always trade at a premium. For fast-growing technology companies, it's because investors are pricing in many years of continued success. For others, it's about the quality of the business.
That's been the case for Costco Wholesale (COST 0.34%) for more than a decade. Ironically, it's a company known for low prices, but it trades at a premium. Comparing it to rivals shows just how well the company has performed over time and why it deserves the lofty valuation.
A perpetual premium
Costco's two main rivals are BJ's Wholesale Club Holdings (BJ -0.82%) and Walmart's (WMT -1.08%) Sam's Club. The latter is entwined in the superstore's larger business. But BJ's Wholesale is a standalone public company after a 2018 initial pubic offering. It had previously been taken private in 2011. It's clear Wall Street favors Costco. It's paying significantly more per dollar of revenue.
That illustrates the the premium in its industry. Comparing it to the market as a whole -- and going further down the income statement -- tells the same story. The company is almost always trading at a premium to the market.
An interest-free loan from suppliers
One of the most often-cited metrics highlighting Costco's business model is its cash conversion cycle. It's the number of days it takes to convert the cash invested in goods into cash from sales.
As an example, companies buy products to sell to customers. The shorter the time between those two actions, the less money they have tied up in inventory. For Costco, the number is currently negative. That means its customers are paying for products off the shelf before it has paid its suppliers. Essentially, the suppliers are funding the business.
The number has always been extremely low, even compared to longtime industry benchmark Walmart. By contrast, BJ's Wholesale takes more than eight days to turn inventory into sales. That time is money.
Fuel for growth
Executed well, that business model produces a lot of free cash flow. And Costco's has more than tripled in the past decade. That's allowed it to fund growth without taking on much debt. The number of warehouses has increased from 592 in 2011 to 815 by October of last year. With its recent push into China, the growth could persist for decades more.
The company has accumulated about $7.5 billion in debt, which it can cover easily. Costco's times interest earned ratio -- or the number of times its earnings before interest and taxes (EBIT) can be divided by the interest it pays on debt -- dwarfs its rivals. The company's EBIT is more than 60 times its annual interest payment.
An earned premium that isn't likely to go away
The stock market ebbs and flows over time, with skepticism and exuberance taking turns making stocks pricey or cheap. But some businesses are recognized on Wall Street as so strong they're never cheap. Costco is one of them. How its business model helps fuel growth out of the pockets of others is the primary reason why. With decades of operational experience behind it and an enormous growth opportunity ahead, don't expect the stock to look cheap anytime soon.