One clear sign of an excellent investment is when the company creates a cult-like following among its customers. Who shops at Costco Wholesale (COST 1.01%) and doesn't know about and appreciate the company's famous $1.50 meal deal for a large hot dog and soda?
The high regard for the company has translated into a high regard for the stock as well. Costco stock has trounced the returns of the S&P 500 over the years, returning an astounding 118,000% over its 38-year life as a public company. Costco is admittedly a wonderful business.
And yet, it's also one that potential new investors should stay far away from in 2024. There is a severe problem with the stock today that could easily derail the stock's short-term investment returns.
Costco's profits don't all come from selling goods
At first glance, it's easy for investors to assume that Costco makes its profits from selling products. A closer look at its financials shows that nearly three-quarters of its profits actually come from the membership dues customers pay annually for access to its warehouse stores.
It's the company's secret sauce. Costco received $1.082 billion in membership fees in the first quarter of its fiscal 2024 (quarter ending Nov. 26, 2023), which was up about 8% year over year.
COST Normalized Diluted EPS (TTM) data by YCharts
Membership fees are very high margin, which is why it's such an outsize contributor to Costco's bottom line. That makes the stock's formula for generating returns simple. Open more stores, sell more memberships, and the business grows. That formula has produced consistently stellar earnings growth for years, hence the fabulous investment returns.
So, what's the problem?
The stock market is sometimes a popularity contest. Costco is the cool kid everyone wants to be friends with, the stock every investor wants to own. Really popular stocks often command higher valuations simply because there's demand for shares.
If the valuation tells you how popular a stock is, Costco hasn't been this popular since the dot-com stock market bubble in the late 1990s.
COST PE Ratio data by YCharts
A lofty valuation by itself isn't a problem. The issues only arise when there is a mismatch between a stock's valuation and the company's business performance. In other words, the company's performance must justify the high valuation the market is paying, or it won't continue paying that price.
Can Costco live up to its hype?
This is where the cracks begin to show in Costco stock today. Costco, a consumer-driven business, faces a lukewarm business climate. Consumer sentiment is below its historical averages. If you've been to a grocery store or fast-food restaurant lately and experienced how much prices have risen recently, you may understand why sentiment is soft.
Analysts think that these headwinds could slow down Costco's earnings growth. They recently lowered their estimates for long-term earnings growth to an 8% annualized growth rate.
COST EPS LT Growth Estimates data by YCharts
Costco stock could be in for some pain if those estimates are accurate. The stock is trading near its all-time-high share price, and its price-to-earnings ratio (P/E) is 44 using estimates for Costco's fiscal year ending in August. Even looking forward, the stock's PEG ratio is over 5.
Generally, for the PEG ratio, which values the stock against its growth rate, I look to buy stocks at ratios under 1.5. In that light, Costco stock is costly for the earnings growth analysts are calling for. Heck, the stock could fall 50%, or earnings growth could end up doubling analysts' expectations, and there is an argument the stock still wouldn't be a good value buy.
Not to be dramatic, but Costco stock's valuation feels like a runaway train. It's a fantastic company and stock to buy and hold at a reasonable price, but don't get run over trying to hop aboard the stock at these prices.
