Insights

Here’s Why I’m Not Buying Costco Stock Just Yet

Shares of Costco Wholesale (NASDAQ: COST) have doubled in value over the last two years. Costco is experiencing strong sales growth as consumers flock to stores to find the best value with consumer prices rising across everyday goods. But there’s one important reason I’m not buying the stock yet.
Valuation
Costco is very efficient with volume purchasing and keeping costs down so it can pass the savings on to customers. In the fiscal second quarter (which ended Feb. 27), comparable sales increased by 14% year over year. That is significantly higher than the 9% growth reported in the same quarter two years ago. 

Image source: Getty Images.

The problem is that the stock has appreciated twice as fast as the company’s growth in earnings per share over the last two years. 
The soaring share price wouldn’t be a problem if the stock was climbing off a cheap valuation. But Costco already looked fairly valued at the start of the stock’s ascent, trading at a price-to-earnings (P/E) ratio of about 35 times earnings at the start of the pandemic. Over the last two years, Costco’s P/E multiple has increased 35% and now sits at 45. That is nearly twice the P/E of the S&P 500 index.

COST PE Ratio data by YCharts
What’s wrong with a high P/E?
Costco might be able to justify a higher valuation if it could sustain its recent sales and earnings growth. However, prudent investors should expect Costco’s growth rate to eventually revert to pre-pandemic levels. In the five years leading up to the pandemic, Costco’s comparable sales growth ranged in the single digits every year, as opposed to the double-digit increases we’ve gotten used to recently.

Metric
Fiscal 2021
Fiscal 2020
Fiscal 2019
Fiscal 2018
Fiscal 2017

Comparable sales growth
16%
8%
6%
9%
4%

Data source: Costco Wholesale. Costco’s fiscal year ends on the Sunday nearest the end of August.
There’s already early evidence this is happening. In the fiscal second quarter, Costco’s e-commerce growth came in at 12.5%, which was down from 76% in the year-ago quarter. 
The consensus analyst estimate expects Costco to report total sales growth of 8.3% this year before decelerating further to 5.6% next year. That spells problems for investors paying exorbitant valuation levels to buy Costco.
Investors should remember what happened in the past to those who continued to pay higher and higher P/E multiples to own shares of leading companies.
During the bull market in the 1990s, shares of leading growth stocks like Coca-Cola, Walmart, and Microsoft skyrocketed to P/E ratios similar to Costco’s current valuation. Investors who paid those high valuations saw those stocks go nowhere for 10 years even though Coke, Walmart, and Microsoft continued to grow earnings per share (EPS).

KO data by YCharts 
Costco is a great business that treats its employees well, and it offers tremendous value to shoppers. But I can’t justify paying roughly twice the S&P 500 P/E to buy shares. That valuation gap implies there are much better values out there. If other investors begin to reach that same conclusion, Costco stock could face a prolonged period of stagnant returns as we’ve seen before. 
John Ballard has no position in any of the stocks mentioned. The Motley Fool owns and recommends Costco Wholesale and Microsoft. The Motley Fool has a disclosure policy. –

Shares of Costco Wholesale (NASDAQ: COST) have doubled in value over the last two years. Costco is experiencing strong sales growth as consumers flock to stores to find the best value with consumer prices rising across everyday goods. But there’s one important reason I’m not buying the stock yet.

Valuation

Costco is very efficient with volume purchasing and keeping costs down so it can pass the savings on to customers. In the fiscal second quarter (which ended Feb. 27), comparable sales increased by 14% year over year. That is significantly higher than the 9% growth reported in the same quarter two years ago. 

Image source: Getty Images.

The problem is that the stock has appreciated twice as fast as the company’s growth in earnings per share over the last two years. 

The soaring share price wouldn’t be a problem if the stock was climbing off a cheap valuation. But Costco already looked fairly valued at the start of the stock’s ascent, trading at a price-to-earnings (P/E) ratio of about 35 times earnings at the start of the pandemic. Over the last two years, Costco’s P/E multiple has increased 35% and now sits at 45. That is nearly twice the P/E of the S&P 500 index.

COST PE Ratio data by YCharts

What’s wrong with a high P/E?

Costco might be able to justify a higher valuation if it could sustain its recent sales and earnings growth. However, prudent investors should expect Costco’s growth rate to eventually revert to pre-pandemic levels. In the five years leading up to the pandemic, Costco’s comparable sales growth ranged in the single digits every year, as opposed to the double-digit increases we’ve gotten used to recently.

Metric
Fiscal 2021
Fiscal 2020
Fiscal 2019
Fiscal 2018
Fiscal 2017

Comparable sales growth
16%
8%
6%
9%
4%

Data source: Costco Wholesale. Costco’s fiscal year ends on the Sunday nearest the end of August.

There’s already early evidence this is happening. In the fiscal second quarter, Costco’s e-commerce growth came in at 12.5%, which was down from 76% in the year-ago quarter. 

The consensus analyst estimate expects Costco to report total sales growth of 8.3% this year before decelerating further to 5.6% next year. That spells problems for investors paying exorbitant valuation levels to buy Costco.

Investors should remember what happened in the past to those who continued to pay higher and higher P/E multiples to own shares of leading companies.

During the bull market in the 1990s, shares of leading growth stocks like Coca-Cola, Walmart, and Microsoft skyrocketed to P/E ratios similar to Costco’s current valuation. Investors who paid those high valuations saw those stocks go nowhere for 10 years even though Coke, Walmart, and Microsoft continued to grow earnings per share (EPS).

KO data by YCharts 

Costco is a great business that treats its employees well, and it offers tremendous value to shoppers. But I can’t justify paying roughly twice the S&P 500 P/E to buy shares. That valuation gap implies there are much better values out there. If other investors begin to reach that same conclusion, Costco stock could face a prolonged period of stagnant returns as we’ve seen before. 

John Ballard has no position in any of the stocks mentioned. The Motley Fool owns and recommends Costco Wholesale and Microsoft. The Motley Fool has a disclosure policy.

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