The Valuation of Costco Stock Is a Tough Pill to Swallow

COST stock has an above-average valuation, despite the company's slowing growth trends

Shares of big-box retailer Costco (NASDAQ:COST) have been on a tear over the past few months. Since bottoming out on Christmas Eve 2018, Costco stock has rallied nearly 30% to fresh all-time highs.

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There have been a few catalysts for the rally of COST stock. Most importantly, macroeconomic conditions in the U.S. have improved, global financial markets have stabilized, and Costco’s numbers have remained strong in 2019, even though many expected COST to do poorly this year. Oil prices have also moved materially higher this year, providing a nice tailwind to Costco’s gas business.

Overall, Costco has simply stayed the course in 2019, and that’s a good thing, considering many expected macroeconomic weakness to take this company off its winning course. That hasn’t happened, so Costco stock has stayed in rally mode.

But the current rally of Costco stock seems slightly overdone. While the economy isn’t on the verge of collapse, it is slowing, and it does appear like it’s only a matter of time before things do get ugly. The U.S. may be just one to three years away from a recession. Heading into this slowdown, Costco stock is trading at an above-average valuation with a below-average dividend yield. That doesn’t make sense. It especially doesn’t make sense, considering Costco’s growth rates have slowed as the economy has slowed over the past few months.

In other words, Costco stock is currently priced for perfection, and perfection isn’t going to happen. Instead, there will be some bumps in the road over the next few months, and those bumps will cause material weakness in COST stock, given its perfect valuation.

Costco’s Growth Is Slowing

To be clear, Costco is a great company with a genius business model, and the company is essentially the offline version of Amazon (NASDAQ:AMZN). This “offline Amazon” business model has long-term staying power, and over the next five to ten years, Costco’s sales, margins, and profits will rise. That will ultimately cause Costco stock to rise.

But COST stock will experience some turbulence in the near-term.

Right now, Costco’s growth is slowing. In late 2018, this company was rattling off 8%-plus comparable-sales growth months in the U.S., and 7%-plus comparable-sales growth months across the globe. From December 2018 to February 2019, Costco’s growth trajectory slowed meaningfully. U.S comparable sales growth slowed to just over 7%, while global comps fell below 7%.

Things got even uglier in March. U.S. comps ex fuel rose just 5.5%, while they rose just 5.9% globally. Moreover, COST’s March 2019 numbers got a 1%-plus boost from a shift in the Easter holiday in 2019. Excluding that one-time boost, U.S. comparable sales growth ex-fuel in March was 4.5%, at best. That was down from over 10% in November 2018.

Not surprisingly, Costco’s slowdown has coincided with a broader economic slowdown in the U.S. On a positive note, most analysts and investors expect this slowdown to end soon, and they predict that the economy will improve over the next few months, thanks to low rates and a potential resolution of the trade war between the U.S. and China.

Nonetheless, U.S. economic growth is still weaker than it was a year ago, and that’s showing up in Costco’s numbers. Consequently, Costco’s numbers over the next few quarters likely won’t be as good as they have been over the past few quarters, and that’s bad news for Costco stock.

Valuation Is High

Despite the company’s slowing growth, the valuation of Costco stock suggests that the company’s growth is accelerating.

The forward earnings multiple of Costco stock is 29. Over the last five years, the average forward multiple of Costco stock has been between 26 and 27. Thus, COST stock currently trades at a premium to its historical average valuation. Further, Costco stock currently has a dividend yield of under 1%, versus a historical average yield north of 1%, so the stock currently features a below-average yield, too.

Yet, the economy is slowing, and Costco’s comparable-sales growth trajectory is flattening. That doesn’t make sense. Usually, above-average valuations are given to stocks with accelerating growth trajectories and below-average valuations are given to stocks with flattening growth trajectories. But,Costco stock has an above-average valuation, even though its growth outlook is flattening.

That isn’t an attractive combination. Ultimately, it’s a recipe for a pullback unless the company’s growth improves dramatically. I don’t think the latter scenario will materialize anytime soon. Thus, a pullback of Costco stock over the next few months looks likely.

The Bottom Line on COST Stock

Costco stock is a long-term winner, but its current valuation implies that the near-term outlook of the stock is unfavorable.As long as slowing growth trends persist, the valuation of COST stock is not supported by the company’s fundamentals.

As of this writing, Luke Lango was long AMZN. 

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