Most investors are probably familiar with Costco Wholesale (COST -0.91%). With fiscal 2023 net sales of $238 billion, it's the world's third-biggest retailer, behind only Walmart and Amazon. It's a consumer favorite thanks to its low prices.
This top retail stock has also been an investor favorite, producing a total return of 215% in the past five years. That trounces both the S&P 500 and the Nasdaq Composite. I'm sure Costco shares are on your investing radar. But before you rush to add the stock to your shopping cart, here are three must-know facts.
1. It has a powerful competitive edge
Costco's massive sales base is the key to its ongoing success. In other words, its scale makes up its competitive advantage.
There are very few businesses that have the buying power and negotiating leverage that Costco does. Suppliers of various merchandise have no choice but to play ball; otherwise, they will lose out on a tremendous sales channel. Furthermore, the fact that Costco carries fewer stock-keeping units leads to the purchase of a higher quantity of goods.
The company operates no-frills warehouses that require minimal inventory handling. Controlling costs translates to savings that are passed on to consumers in the form of everyday low prices. And as these customers continue shopping at Costco, generating higher revenue for the business, it provides even greater negotiating leverage in a positive feedback loop.
2. Its special business model
Not just anyone can walk into one of Costco's 876 warehouses and start shopping. The business requires its customers to pay for an annual membership, a crucial factor in its success.
The retail sector is already intensely competitive, but this business has figured out how to drive customer loyalty and repeat purchases. It helps explain why Costco has been able to consistently grow same-store sales over the years.
The basic membership plan costs $60 annually. If that seems like a hefty price tag, consider the savings that shoppers can enjoy over the course of 12 months. If a household visits Costco once per month, I would bet the money saved on everything they buy more than covers the annual fee.
Costco understands this dynamic, so it tries not to mark up its merchandise by more than 11%. The goal isn't to make huge profits on the sale of goods. Instead, it's all about boosting high-margin income from membership fees, a valuable recurring revenue stream.
The company currently has 73.4 million membership households, with a 90.5% worldwide renewal rate. These are strong figures that investors should keep tabs on.
3. The stock's high valuation
Because Costco shares have been such a huge winner in the past, the market has bid them up to an expensive valuation. They trade at a price-to-earnings (P/E) ratio of 47. That's about as high as the valuation multiple has gotten in the last decade. (The stock did carry an even higher P/E before it reported weaker-than-expected revenue for its fiscal 2024 second quarter in early March.)
It's reasonable to assume that Costco won't be registering the same type of growth it has in the past. According to consensus analyst estimates, the business is set to increase revenue by 6.2% annually between fiscal 2023 and fiscal 2026. That doesn't justify the current valuation, in my opinion.
I wholeheartedly agree that this is a phenomenal business with a track record of shareholder returns that speaks for itself. But I believe that the stock is extremely overvalued right now. Unless there's a sizable pullback, I'm keeping Costco on my watch list.
