Paying a high premium for shares of a publicly traded company comes with significant risk. Namely, if the stock falls out of favor for one reason or another in the coming years, multiple compression (a declining price-to-earnings ratio, for instance) alone could seriously hinder shareholder returns, even if the underlying business is doing well. For this reason, investors may want to seriously consider limiting their portfolio's exposure to highly valued stocks. Further, investors should limit their investments in highly valued stocks to those with a very good probability of sustaining earnings growth for years (and hopefully even decades) to come.
With these considerations in mind, Costco (COST 3.25%) is arguably one of those rare companies worth its high price-to-earnings multiple. Here's why investors may want to consider buying shares of the membership-based wholesale grocer.
NASDAQ: COST
Key Data Points
A customer-friendly business
The first thing investors should try to ensure they're getting when they are paying a high valuation multiple for a stock is a durable business model. To this end, it makes sense to look for a business model that is extremely customer friendly -- one that delivers significant value and satisfaction to its customers.
Fortunately, a customer-friendly value proposition is the core of Costco's business model. The company flexes its negotiating power with suppliers to acquire good deals for its members. Costco gives suppliers an opportunity to sell a limited number of products in high volume, and generally in wholesale quantities. By keeping its stock-keeping unit (SKU) count low relative to normal grocery stores while also optimizing for high volumes to its 64.4 million member households across just 829 warehouses (as of the end of Q3), operating efficiencies are naturally built into Costco's business. Management then passes on the savings from its economies of scale to customers, choosing to consistently operate on razor-thin operating margins. Indeed, its membership fees as a percentage of sales account for nearly all of Costco's net profit margin, which is consistently below 3%.
Known for its great deals for its members, it's not surprising that Costco benefits from a high member renewal rate of more than 92%.
Image source: Getty Images.
A shareholder-friendly business
In addition to providing substantial value to customers, Costco is well-known for taking care of shareholders. The company is relentless about how it stewards its cash on hand, so much so that it has been able to not only rapidly grow its store count over the last decade but also pay a regular dividend and occasional special dividends. In addition, it regularly uses some capital for repurchasing its own shares.
Since the company started paying shareholders a dividend in 2004, its annual payout has increased at a rate of 13% annually. In addition, just as the company passes on savings from its efficient operating model to customers, it passes on excess cash to shareholders in the form of a special dividend. For instance, Costco paid out special dividends of $7, $5, $7, and $10 per share in 2012, 2015, 2017, and 2020, respectively.
With a customer-centric business model and a shareholder-friendly management team, it's not surprising that Costco has demonstrated substantial earnings-per-share growth -- and continues to do so. Between 2017 and the trailing-12-month period, Costco's earnings per share has more than doubled, increasing from $6.11 to $12.73. Meanwhile, the company continues to post double-digit earnings-per-share growth, with earnings per share in the company's most recently reported quarter rising 10.5% year over year. Further, the current consensus analyst forecast calls for earnings per share for the company's current fiscal year to rise about 19% year over year.
Costco's flywheel of delivering exceptional value for customers should help the company continue growing its membership base while also funding further store count growth and global expansion, driving earnings growth for years to come.
Of course, no investment is without risk. With Costco stock, there's always a chance that investors decide the stock isn't worth the high premium investors are paying today, leading to poor investment returns. But when there's a high probability of earnings growth like this for a decade a more, and when the company is known for being a good steward of shareholder capital, a high price tag is often worth paying.
