At any given moment, the stock market gives investors a glimpse into how others perceive a particular business. And it's no surprise that some of the best companies carry valuations that reflect this quality. But astute investors who practice patience might be able to buy at better prices.
An outstanding and well-known business, Costco Wholesale (COST -0.32%), reached its all-time high of $605 a share in April of this year. And at that time, the price-to-earnings (P/E) multiple was at a blistering 49, an expensive valuation.
Investors might have exited their Costco positions in April when shares peaked, correctly calling the top. But does this mean they can never own this top retail stock again? With shares down 20% from that high, it might be time to take a closer look.
Understanding valuation
At a P/E of 49, Costco's valuation in April was signaling unheard-of future growth for the business. The stock hadn't been that expensive in over 20 years. And with a market cap of $215 billion and fiscal 2022 total revenue of $227 billion, it's hard to imagine Costco's growth prospects suddenly being better than they have been historically when the enterprise was smaller and had more room to increase market share. The law of large numbers takes effect, making it difficult for a business of this magnitude to keep up rapid expansion indefinitely.
Consequently, shrewd shareholders might have recognized that the valuation was stretched in April, and smartly would have exited their positions.
Focus on quality
Costco continues to do well in a weakening macroeconomic environment. In the fiscal 2022 fourth quarter, total revenue jumped 15% year over year, with same-store sales (or comps) increasing 13.7%. And in September and October, comps jumped 8.5% and 6%, respectively, still showing solid momentum.
The company is known for providing customers with some of the lowest prices around. This is possible thanks to Costco's massive scale. As one of the world's biggest retailers, it has tremendous negotiating power with vendors, pushing for lower per-unit costs on the merchandise it sells. Shoppers benefit from extremely low prices.
But because Costco intentionally operates with low margins, it relies on an incredibly successful membership-based model to drive increased customer loyalty and profit. As of Aug. 28, the business counted 65.8 million membership households, with a worldwide renewal rate north of 90%. And management most likely has untapped pricing power with these memberships.
A key attribute for the company is that it is not prone to technological disruption that we see with high-tech companies. So decades from now (an otherwise impossible forecasting period), it's reasonable to assume that Costco will probably be doing the same thing it does today -- which is the same thing it has done since its founding almost 50 years ago.
Patiently watch the stock
Costco is a stellar business, and it has been for a long time. This has made the stock a great investment over the years. But valuation still matters, so investors who sold earlier this year as the stock hit its all-time high made the right move.
Nonetheless, because Costco is a high-quality enterprise, smart investors should have kept the stock on their watch lists, patiently waiting for the valuation to come back down to more reasonable levels.
Right now, Costco shares are trading at a P/E of 37, well below the 49 number in April, but still above the trailing-five-year and 10-year averages. Investors who believe in Costco's long-term prospects might want to consider repurchasing the stock simply because the valuation is more attractive right now, with no deterioration in the business' quality.
That being said, if investors think Costco's stock price still has more room to fall, particularly as the Federal Reserve continues its aggressive tightening policy and tries to pump the brakes on the economy, then it might be a good idea to wait for an even more attractive valuation. Timing the market is a tough game, so maybe dollar-cost averaging into the stock is the correct approach.
Just because you decided to sell a stock doesn't mean that it can't once again find its way into your portfolio some day. Exceptional companies are rare, so it's always a good idea to keep tabs on ones you've sold in the hope that the price provides a solid buying opportunity again, given that the company's quality hasn't deteriorated.
