Insights

Is Costco Stock Worth Paying Up for?

People like dependable stocks during turbulent markets, and big-box retailer Costco Wholesale (NASDAQ: COST) has undoubtedly been reliable for shareholders. The financial crisis in 2008-2009 was the last time the stock declined more than 40%, and it’s currently just 10% from its high despite the broader market’s 14% decline in 2022.

However, what feels safe might not always be the best investment. Consider this important fact before putting new money into Costco stock.

Proven winners feel like safe stocks

Costco is famous for its great deals, including its legendary $1.50 hotdog-and-soda combo meal. Warren Buffett’s right-hand man, Charlie Munger, is a longtime shareholder and even serves on the board of directors to this day.

Investors love the stock — and for a good reason: It’s returned more than 60,000% over its lifetime.

COST data by YCharts.

That track record feels safe. Costco’s conservative management team keeps $11.2 billion in cash on hand, more than the total debt on the balance sheet — another sign of a company built to endure and grow.

Revenue has increased by an average of 8.6% annually over the past decade, while net income has grown  at a 13.6% rate over that period. Seriously, there isn’t much to not like.

Costco is the secret that everybody knows already

Sometimes the problem with a company that does so many things right is that everyone knows about it. Costco is no hidden gem, and its strong fundamentals have given its shares a premium valuation.

The stock’s median price-to-earnings ratio (P/E) over the past decade is a lofty 29. Yes, the company’s profits are growing faster than the 9% to 10% annual rate that the S&P 500 averages over its history, but a P/E of 29 is a significant premium considering the S&P 500’s historical average P/E is just 16.

But it’s gotten worse since the pandemic; investors have kept piling into Costco stock and the valuation has crept higher. Now at a P/E of 43, the stock is becoming excessively expensive.

COST PE Ratio data by YCharts.

Investors have a fundamental question to answer when a stock’s valuation becomes an outlier — namely, have the company’s fundamentals changed to justify a dramatically higher or lower valuation, or is the market being silly? A silly market means that the stock will likely return to its norm at some point.

Can Costco justify its lofty price tag?

In other words, can Costco justify its higher valuation, or is the stock likely to regress? Costco’s earnings per share (EPS) have grown 13.5% annually over the past 10 years.

Of course, the next decade could see the same type of growth. However, analysts believe that growth will slow, with estimates calling for an average of 9% annual EPS growth over the next three to five years.

Investors are flocking to Costco for its dependable business model today, but once all the noise in the market quiets down, will they be willing to pay so much for the stock? It doesn’t seem likely, especially when a more confident market begins moving back to growth stocks that have already lost much of their value and trade at bargain-basement valuations.

That’s not to say that Costco can’t be a winner over the next 10 years and beyond, but there could be some regression in the shorter term. You could consider waiting for the stock to come down before buying shares if that concerns you.

Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy.

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