Costco (NASDAQ:COST) looks a little pricey when compared to its own historical valuations. Should investors pay up for a great business that has never been stronger? As a longtime owner, I think it's a great time to pick up some shares for the long term.
Costco is an international warehouse retailer, with 672 stores as of April 15, 2015. It's predominantly based in the United States and Puerto Rico, where it owns 474 of its locations. More than 78 million people are Costco cardholders.
It has been a phenomenal success story based on a number of metrics. It's stock price has risen from $56 per share to more than $140 in the last five years, good for a 20% compound annual growth rate. Charlie Munger, one of the world's greatest investors and a director at the company, has said, "I believe Costco does more for civilization than the Rockefeller Foundation."
Historical valuation comparison makes the company look a bit pricey
Using the conventional valuation tools of price to earnings, price to book, and price to sales, Costco stock appears to be slightly overvalued compared to its five-year historical averages. Costco stock has very rarely ever ventured into "bargain price" territory because it's such an excellent business. For comparison's sake, Wal-Mart sports a five-year average P/E of 14.3.
|Costco||Costco 5-yr avg.|
Explanation of business model and SG&A expensesCostco's business model relies on operating with razor-thin margins. It's company policy not to mark up any product by more than 15%. This is reflected in their financials, as their cost of goods sold, or COGS, has consistently remained roughly 87% of revenue.
To succeed, Costco must keep SG&A expenses as low as possible, and it historically has been successful in doing so. For the past 10 years, it has kept that figure right around 10% of revenue, while Wal-Mart's has hovered between 18% and 19.5%.
Costco also has managed to reduce this expense from more than 10% in 2009 and 2010 to less than 10% in every year since. While this may not seem like much, with margins this tight, every small fraction of a percentage counts.
That leaves Costco with an operating margin slightly above 3%. After accounting for interest expenses and taxes the company is left with a net margin of 1.99% on a trailing 12-month basis. This is even lower than WalMart's TTM net margin of 3.32%. With margins this tight a business must be operated with great efficiency to have the historical success that Costco has enjoyed.
Business is operating better than ever before
Return on equity, or ROE, is a way to measure the efficiency of a business. It measures the percentage return for every dollar of shareholder equity invested in the business. Costco's was in the 12%-14% range from 2005-2012, jumped into the 17% area for 2013-2014, and is 20.59% on a TTM basis.
When one sees a jump like this, it's important to check to see if the company has taken on a substantial amount of long-term debt. If this debt is producing returns, it will skew the ROE number.
Long term debt has increased from $1.38 billion in 2012 to around $5 billion in 2013 and 2014. This increase, while substantial in real terms, still leaves Costco less leveraged than competitors such as Wal-Mart and Target.
With $33.491 billion in assets on the balance sheet as of the period ending May, 10, 2015, and $4.826 billion in LT debt, its LT debt-to-total-assets ratio is 14.1%. This is lower than the most recent numbers from Wal-Mart and Target, which came in at 21.4% and 31.3%, respectively. Suffice it to say Costco's balance sheet remains very strong.
Finally, a look at the return on invested capital, or ROIC, reaffirms that the business has been getting stronger in recent years. ROIC accounts for all invested capital, not just equity, and thus factors in the addition of debt to a company's balance sheet. Costco's ROIC has ranged from around 10%-12% from 2005-2011, and in subsequent years, has been 12.69%, 14.24%, 12.83%, and finally 13.78% on a TTM basis. This is the sign of an already wonderfully managed company excelling even further.
While Costco shares are off their all-time high of about $156 the future prospects of the company look appealing.
James Sullivan owns shares of Costco Wholesale. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.