Big-box retailer Costco Wholesale (COST 1.01%) is one of those companies that keeps chugging along. A shopper's club most known for selling $1.50 hotdogs has grown into a global empire with more than $235 billion in annual sales.
The right-hand man of Warren Buffett himself, Charlie Munger (a stellar mind in his own right), sits on the company's board of directors. The stock has returned more than 93,000% over its lifetime.
What's not to like?
Well, there is one thing. It's a big enough deal that investors should think twice about owning the stock... at least right now. Here is what you need to know.
Costco's stellar reputation has impacted the stock
You'll be disappointed if you're looking for me to take shots at Costco's business. The company is truly a powerhouse and blue chip stock. It sells bulk items at razor-thin margins and tremendous volume, making its profits from membership dues it charges shoppers for store access. It's been a remarkably successful formula for years:
COST Revenue (TTM) data by YCharts
Want to compete with Costco? Good luck! The company makes just $5.8 billion in free cash flow on $235 billion in sales, just over two pennies on each dollar. Additionally, the company has more cash than debt on its balance sheet and doesn't spend money on advertising because its company logo and $1.50 hotdog are so well known.
But the problem for investors today is that most people know how great Costco's business is, which translates to the stock, which has become increasingly popular due to its strong fundamentals in a market that's become somewhat volatile over the past couple of years.
Examining Costco's valuation further
An excellent business can be a lousy investment if you dramatically overpay for the stock. Costco is potentially setting new investors up for subpar returns moving forward. Analysts believe the company will grow earnings by approximately 11% annually over the long term.
However, the stock is trading at nearly 39 times its estimated 2023 earnings. That's a price/earnings-to-growth (PEG) ratio of 3.5, which implies the stock is costly relative to its expected growth.
COST EPS LT Growth Estimates data by YCharts
Check out the S&P 500, which trades at a forward P/E of 20 to compare. The stock market has averaged about 10% annual growth over the long term, creating a benchmark to compare Costco to. In other words, you can invest in the broader market and get roughly 10% annual growth, or Costco for nearly double the valuation and marginally better growth.
What should investors do?
That is a red flag because such an expensive valuation poses a risk to shareholders. For example, a recession could hit the economy, slowing the company's growth. The market may decide the stock isn't worth such a premium and rerate lower, a potential disaster for investors who bought shares at a high price.
Or, the stock could stagnate as Costco's business grows and catches up to the stock's valuation over the coming years. At 11% annual growth, Costco could take roughly six years to increase profits enough to bring the valuation down to 20 times earnings.
If you own shares, you could hang on to them and continue buying once the valuation makes more sense. New investors should consider avoiding the stock altogether at this price. Either way, it looks like Costco is a wonderful company that trades at far too high a valuation to translate that quality to similarly stellar investment returns.
