Giving full credit where it’s due, Costco Wholesale Corporation (NASDAQ:COST) has done a reasonably good job of fending off bigger and better competition, holding off Wal-Mart Stores Inc (NYSE:WMT) on the brick and mortar front, while keeping Amazon.com, Inc. (NASDAQ:AMZN) more or less in check in terms of e-commerce. Sales and earnings are still growing, even if at a snail’s pace.
There comes a time, though, when every shareholder of a company has to ask themselves “Can this company’s growth and prospects really justify this stock’s valuation?”
With a Costco stock price that’s now 25 times next year’s projected per-share earnings, it’s past time for Costco stock owners to start asking the question. Sooner than later, traders are going to realize the risk/reward scenario of COST is relatively long on risk, and relatively short on reward, with or without the brewing headwind of the Amazon/Whole Foods team-up.
Costco’s Prices Are Low, but Its Stock Isn’t
I’m all too aware of the mostly-bullish consensus opinion on Costco stock. Professional stock-pickers collectively rate COST is just a little under a “Buy,” (versus a best-possible rating of “Strong buy”) and have an aggregate COST stock price target of $181.33. That’s 10% better than the stock’s current value near $164, by the way, suggesting analysts don’t think investors appreciate what Costco really is.
Gotta be honest though, I just don’t get see the attraction in paying more than 25 times next year’s expected earnings, when that earnings figure is only 5.6% better than 2017’s projected earnings per share of Costco stock.
I know, I know, valuations are mostly irrelevant now. Growth rates don’t mean much more these days either. It’s all about the story, and finding (relative) momentum. I get it. Thing is, in my near-20 years on the market, as a profession, I’ve learned a few things. One of the key overarching lessons I’ve learned is, valuations don’t matter right up until the point they do matter. And once they do start to matter, they matter in spades.
That’s the polite way of saying the COST stock price can only hover in the mid-to-high-20 P/E range for so long before investors insist the company justifies the premium.
I don’t see that happening very soon, particularly now that Amazon is tiptoeing further into Costco’s turf with its recent acquisition of grocer Whole Foods.
The image below tells part of the tale, looking back at the company’s recent historical results, and looking ahead at revenue and earnings projections for the next couple of years. They’re not bad. They’re certainly not the kind of growth you’d expect from a retail stock that’s priced more optimistically than Apple Inc. (NASDAQ:AAPL) or Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) shares are, both of which are reliably growing faster than Costco is.
But the future looks better than the past, at least in terms of the bottom line? True enough. Just bear in mind, though, that Costco is a 50/50 proposition when it comes to earnings; it falls short of estimates about half the time. The outlook may be as erroneously optimistic as the past estimates were, and since 2013, the company’s average earnings growth has been right around 5%.
As a rule of thumb, a stock’s P/E ratio should be the same as its earnings growth rate. That is to say, if a company’s earnings growth pace is 12%, the stock should trade at a trailing P/E of 12. If an organization is growing the bottom line at a 20% clip, a frothier earnings multiple of 20 is justified.
By that standard, the current Costco stock price is arguably four times greater than it should be. Such a valuation was a stretch when Amazon wasn’t in the grocery business. Now that price is downright unpalatable, unpalatable enough to prompt three downgrades of Costco stock in just the past few weeks. More are likely in the cards, as reality comes home to roost.
Bottom Line for Costco Stock
In its defense, you certainly could do worse. There are plenty of stocks out there that cost more and with underlying companies that are moving forward rather than backward. The U.S. market is saturated, and the U.S. need has been mostly met either by online or offline choices. While some suspect the next big growth initiative from Costco will be a move into China, that’s anything but a sure thing, though it’s sure to be an expensive experiment. Just ask Wal-Mart, which already tried to do the same and ultimately failed.
Bottom line? You can do much better than COST stock. Its era of a premium valuation is nearing an end, as there’s no compelling future to point to as a reason to pay a premium.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter.
