Costco Wholesale (COST 0.87%) recently reported its fiscal 2023 first-quarter (ended Nov. 20) financial results, posting net sales of $53.4 billion, good for an 8.1% year-over-year increase. Earnings per share of $3.07 also showed a slight uptick from the same period last year.
Despite these relatively positive results, Costco missed Wall Street analyst estimates. And the stock is down more than 14% in 2022.
But with a current price-to-earnings (P/E) ratio of 37, are Costco shares currently overvalued? Let's take a closer look at the business and its prospects to find the answer.
A high-quality compounder
Over the past decade, the world's top warehouse club chain has seen its shares rise almost 400%, handily crushing the S&P 500's total return of 240% during the same time. Consequently, Costco's current valuation, based on the widely followed P/E multiple, is meaningfully higher than the stock's trailing 10-year valuation (P/E of under 32).
While the Federal Reserve's aggressive rate-hiking policy has compressed Costco's valuation from a peak of nearly 50 at the end of 2021, it's very telling that the stock is still more expensive than it has been on average in the past decade.
However, a valid argument can be made that Costco does deserve a premium valuation. The business has increased revenue and net income at a compound annual growth rate (CAGR) of 12% and 16.5%, respectively, over the past five years. And during the same period of time, the operating margin expanded from 3.2% in fiscal 2017 to 3.4% in fiscal 2022. This doesn't seem like much of an improvement, but when you consider that Costco posted trailing-12-month sales of $231 billion, even incremental gains in margins can have a profound impact on the bottom line.
Operating an extremely successful membership-based business model also makes an investment in the company look attractive. Customers must pay $60 per year for the basic Gold Star membership to be able to shop at a Costco location. Not only does this provide the business with a revenue source that essentially all turns into profit, but it helps to drive loyalty from consumers. In the latest quarter, the worldwide membership renewal was a stellar 90.4%.
Further supporting Costco's elevated P/E is the relatively low uncertainty about the company's prospects. Rightfully so, the market sold off speculative growth tech stocks this year, as these types of businesses have operations that are unprofitable and exist in industries that seem to be undergoing constant change. Costco's stability, security, and "boring" factor, coupled with the fact that it will most likely be doing the same thing decades from now, surely warrants a premium multiple compared to most stocks out there.
Optimism is more than priced in
Despite Costco's undeniably high quality and incredibly successful business model, I think it's strikingly clear that shares are expensive right now. Ten years ago, the stock was trading at a P/E of 24, far lower than today's price tag. And at that time, Costco's growth prospects were significantly greater than they are today. The business opened 230 net new warehouses and more than doubled annual sales in the past decade, a feat that probably isn't going to happen in the next 10 years.
Therefore, investors who buy shares at the current P/E of 37 have to believe that Costco's future growth will be greater than what was achieved in the past. I just don't see this as a probable scenario given the already massive size of the company, with a market cap of $216 billion today.
To be fair, Costco is clearly not finished expanding just yet. On the latest earnings call, management did mention that the company plans to open 24 net new locations in fiscal 2023. What's more, Wall Street analysts are forecasting that revenue and earnings per share will rise at a CAGR of 7.3% and 11.8%, respectively, over the next five fiscal years.
Add the potential for continued same-store sales growth to periodic membership price increases, which Costco last implemented in June 2017, and there's no doubt that the company's margins and profitability are set to rise as we look ahead. Even so, today's valuation more than prices in a wildly successful future for Costco. And therefore, investors should wait for a substantial pullback in the stock before buying.
