They say past performance doesn't indicate future returns. But investors can look at historical winners to find companies that might continue the momentum.
Take Costco Wholesale (COST 1.01%). This top retail stock has skyrocketed 238% in the last five years, a gain that trounces the Nasdaq Composite by a wide margin. Shareholders are hoping that the stock can keep it up.
Is it likely that Costco shares will double in the next five years?
A wonderful business
The giant retailer has steadily increased its revenue and earnings per share over the past few decades. This strong fundamental performance has been a key ingredient to the stock price rising. What's more, high profits have led to occasional one-time special dividends for investors, boosting returns.
The typical retailer might struggle to get shoppers to continue coming back, but Costco has cracked the code. Consumers must pay an annual membership fee for the right to shop at one of the company's 874 warehouses. But because Costco sells branded merchandise at some of the lowest prices around, it doesn't take many visits for consumers to more than make up the cost of the membership with their savings.
And by having a high-margin recurring revenue stream with the membership dues, Costco is able to mark up its inventory at much lower rates than other big-box retailers because it doesn't necessarily try to maximize the profits from selling goods. The 90.5% worldwide renewal rate for memberships indicates how sticky these are, making things much more predictable for the management team.
Despite what appear to be some very favorable fundamental characteristics, I'm skeptical that the stock can double between now and the beginning of 2029. I don't question that Costco will still be a dominant force in the retail sector in five years, but the current valuation showcases just how high expectations are. After its monumental rise in recent years, the stock trades at a price-to-earnings (P/E) ratio of 49. This is about as expensive as the valuation has been in the last 20 years.
That lofty price tag demonstrates that investors view Costco as a top stock to own during strange economic times. The business thrived throughout the pandemic, and it's a consumer favorite during inflationary periods when budgets are getting stretched thin. And if a recession happens, I think there's a high likelihood that Costco will still find a way to increase sales and profit. This makes it an all-weather stock.
What investors want
If I had to put a number on it, I'd say there's a less than 25% chance the stock can double in the next five years. I'd bet that the P/E multiple will contract meaningfully, maybe toward its historical average, which creates a headwind for shareholder returns.
However, there is a way for this to be a winning stock going forward. And that's if growth can accelerate. After opening 23 net new warehouses in fiscal 2023, management plans to open 31 new locations in the current fiscal year. There's a huge opportunity in China, where Costco currently has six stores, for the business to expand aggressively. Targeting such a massive middle class is a smart strategy.
But as the world's third-largest retailer today, Costco generated net sales of $238 billion last year. It's totally reasonable, then, to expect growth to slow down in the years ahead as the expansion potential naturally diminishes. The current valuation reflects extreme optimism that monster growth will happen indefinitely. I view the shares as being overvalued.
