Membership-based retailer Costco Wholesale (COST 1.01%) may have topped last quarter's earnings estimates, but the sales shortfall sent shares reeling. All told, Costco stock suffered a 7.4% setback last Thursday following Wednesday's post-close release of the company's fiscal Q2 results. It was the worst single day for Costco shareholders in nearly two years.
The sheer scope of the sell-off begs a two-part question: Were Costco shares just too vulnerable headed into the report, and if so, might they still be? The answer to both parts of the question is yes.
Costco's numbers -- all of them
It wasn't a horrible quarter. The retailer turned $58.4 billion worth of revenue into a per-share profit of $3.92, up from the year-ago comparisons of $55.3 billion and $3.30 per share (respectively). The analyst community was only calling for per-share earnings of $3.62.
Same-store sales improved as well -- up 5.8% -- extending an impressive streak of forward progress. And, in retrospect, the expectations of nearly $59.2 billion worth of revenue may have been unfair, at 7% above the year-earlier figure. The stock sold off anyway. Except, maybe the stumble isn't nearly as much about the top-line miss as it seems. More downside shouldn't come as too much of a surprise, either.
See, although it's not been pointed out (much), the extreme outperformance of Costco stock since 2018 isn't something to simply ignore. Shares are up more than 300% from the end of 2017 -- with a great deal of that gain taking shape in just the past few months -- dramatically outpacing the S&P 500's performance for the same time frame. That's huge to the point of being ridiculous.
The stock is now trading at more than 50 times its trailing earnings, and over 40 times next fiscal year's projected earnings of $17.24 per share. Even most of the best-of-the-best growth and tech stocks don't support such valuations for very long, and Costco is neither. What gives? It's crazy, but not complicated.
How Costco stock's crazy valuation got so crazy
Kudos to investors for being willing to pay a premium for a quality name like Costco. Stocks of reliable companies like this deserve above-average valuations. Indeed, the additional up-front cost to investors often ends up paying for itself in the end.
There's such a thing as too much, though. Costco stock has reached that point -- and then some. As noted, shares are trading at more than 50 times their trailing earnings, and boast a forward-looking price-to-earnings ratio of over 40. Both are sky-high. This is the frothiest valuation we've seen Costco trading at since the late-1990s, in fact, when it was still fairly young and spending heavily to reshape itself into what it ultimately needed to become.
The bigger question for interested investors is, however, this: How does this happen? The answer is, sometimes trends take on a life of their own. That is to say, sometimes a rally continues beyond its reasonable life expectancy because investors -- enamored by relentless bullishness -- jump in before missing out on any more upside. There's even a name for the phenomenon: fear of missing out, or FOMO for short.
As is the case with musical chairs, though, eventually the music does stop. That's when investors stop buying. Perhaps they even start selling. The ensuing weakness encourages more investors to rethink their positions or prevent would-be buyers from jumping in. That weakness prompts even more doubt among investors, and so on. All of a sudden, a stock that once commanded incredible premium prices no longer does.
At least a few investors finally started coming to their senses (so to speak) with Costco last week, recognizing that they're paying upwards of 40 times a stock's past and projected profits for a chance to own a stake in a company that does well to grow its top line by 7% per year.
In other words, the music may have just stopped.
Take the hint
Yes, it's absolutely possible to be too stingy when it comes to buying stocks. Just as paying too much for stocks can crimp your returns, being cheap has also done plenty of investors more harm than good. So don't read too much into this message.
Right now, however, frothily priced Costco shares are suddenly showing significant vulnerability to not-so-bad news. That's a hint that investors are nervous about the foreseeable future, which is a bearish clue for the stock in and of itself. It could take several weeks for this bearish overhang to drive the stock back to a more palatable valuation -- probably somewhere nearer 30 times per-share earnings. That's much closer to the metric's long-term average.
Or think about it like this: Would you be willing to pay $100,000 to buy a business that generates annual cash income of only about $500, produces a net after-tax profit of about $2,000 per year, and would never produce annual income growth of more than 10% per year? Most people wouldn't. But, that's essentially what you'd be buying into with Costco shares at their current price.
You could certainly do worse than Costco right now, and plenty of investors have! Right now, you could also easily do much better.
