Shareholders have cheered at Costco Wholesale's (COST 1.01%) performance in past years. The specialty retail juggernaut has watched its stock grow 55% over a one-year span, far ahead of the S&P 500's 5% return during the same time frame. The company has performed extraordinarily well over a longer time horizon, too -- Costco shares have increased 278% in the past five years, equal to an average annualized return of 56%.
So, why has a modestly growing retail company been so successful? I would wager that it has something to do with Costco's sturdy economic moat. And although there are several amiable aspects of Costco's business, there is one particular element that takes the cake. Let's discuss Costco's top competitive edge and what it means to the company's business model.
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Costco's membership model
Costco's membership model is the key ingredient of its recipe for success. It boasts 63.4 million member households. Consumers can't seem to get enough of the shopping experience that Costco offers. The company generated $3.9 billion via membership fees in 2021, representing a 9% increase year over year. Membership fees only comprise 2% of total sales, so on the surface, they appear rather insignificant to Costco's overall business.
But when you examine Costco's income statement in greater detail, you'll find that membership fees make up a walloping 77% of the company's bottom line. And since Costco has a 92% member renewal rate, the company's business is more foreseeable than others. Investors like predictability, and that's exactly what they get from Costco and its membership model.
Likewise, because Costco's membership program allows us to more easily forecast its net profits and cash flow, investors are far more willing to pay up for the stock. This explains why Costco has historically traded at a premium relative to its industry peers.
In short, Costco's membership model offers one element that all shrewd investors look for: Consistency. Without its members, the company wouldn't be able to sell items at industry-low prices, which is the primary reason consumers shop at Costco in the first place. Costco has established itself as a premier retail destination for the global consumer, and it all goes back to its unrivaled membership program.
Is Costco a buy today?
Costco is a world-beater in terms of retail stocks, but its valuation appears a bit too lofty as it stands today. Costco has historically traded at higher levels than its competition, and for many reasons, deservingly so. But even with that in mind, the retail titan is trading well above its historical price-to-earnings multiple. Costco has a price-to-earnings ratio of 46 today, nearly 25% higher than its five-year average of 36.
Given that Costco is only projected to grow its top and bottom line at average annual growth rates of 7% and 10% through 2025, its valuation looks especially high today.
COST PE Ratio data by YCharts
For that reason, I would advise staying on the sidelines for now. This is a case of a fantastic company that doesn't offer a favorable buying opportunity. Interested investors should wait until the stock dips below its historical average price-to-earnings multiple before they consider buying a stake in the company. Great investments take patience and discipline.
We should all be searching for companies with attractive valuations and robust fundamentals. Costco offers the latter today, but unfortunately, its valuation is through the roof. Look to disperse your capital into other investment opportunities today. When the time comes -- which it will -- you'll have your chance to acquire Costco shares at a more affordable price.
