Costco After the Recent Correction-Overvalued Or Undervalued?

Introduction

This is the fourth in a series of articles where I will cover popular and/or high profile stocks. The primary objective of this series will be to put a spotlight on the importance of forecasting future growth prior to making an investment decision. I elaborated on the importance of forecasting future growth in part 1 of this series found here. The central idea is to determine whether or not a reasonable forecast of future growth warrants consideration for investment relative to how the market is currently valuing a given stock.

Furthermore, I believe it’s imperative for long-term success that investors apply their best efforts towards determining the intrinsic value of any stock they are interested in. This is especially true for long-term oriented investors. If you overpay for even a great business, you are very likely to be disappointed with your long-term results.  Overvaluation is an obvious risk that can, and should, be avoided.

However, this principle is not cut and dry as it relates to Costco (COST) because this company has chronically commanded a premium valuation based on earnings.  Consequently, prospective investors are faced with the challenge of being willing to pay a premium multiple of earnings to invest in Costco believing that this premium valuation will continue.  On the other hand, as it relates to operating cash flows and/or EBIDTA, the market has consistently valued Costco more reasonably.  Nevertheless, as the video associated with this article will clearly illustrate, Costco remains highly valued regardless of which metric you apply.

Costco Wholesale Corporation: Hypermarkets and Supercenters

Although I am sure that every reader is familiar with Costco and its stores, the following long business description provides additional granularity on the company and its business:

“Long business description: Courtesy S&P Capital IQ

Costco Wholesale Corporation, through its subsidiaries, engages in the operation of membership warehouses in the United States (U.S.) and Puerto Rico, Canada, United Kingdom (U.K.), Mexico, Japan, Australia, Spain, Taiwan, and Korea.

The company’s average warehouse space is approximately 144,000 square feet, with newer units slightly larger. Its warehouses on average operate on a 7-day, 70-hour week. Gasoline operations generally have extended hours.

The company carries an average of approximately 3,700 active stock keeping units per warehouse in its core warehouse business. Various consumable products are offered for sale in case, carton, or multiple-pack quantities only.

The company offers merchandise in various categories, such as foods (dry foods, packaged foods, and groceries); sundries (snack foods, candy, alcoholic and nonalcoholic beverages, and cleaning supplies); hardlines (major appliances, electronics, health and beauty aids, hardware, and garden and patio); fresh foods (meat, produce, deli, and bakery); softlines (apparel and small appliances); and other (gas stations and pharmacy).

The company sells gasoline in all countries except Mexico, Korea, and Taiwan and operated 508 gas stations at the end of 2016. Ancillary businesses also include optical dispensing centers, food courts, and hearing-aid centers. The company’s online businesses, which include e-commerce, business delivery, and travel, operate Websites in all countries except Japan, Australia, and Spain. They provide its members additional products and services, not found in its warehouses. The company has direct buying relationships with various producers of national brand-name merchandise.

Membership

The company’s members might utilize their memberships at any of its warehouses worldwide. Gold Star memberships are available to individuals; business memberships are limited to businesses, including individuals with a business license, retail sales license or other evidence of business existence. Business members have the ability to add additional cardholders (add-ons). Add-ons are not available for Gold Star members. All paid memberships include a free household card.

Strategy

The company’s strategy is to provide its members with a range of high-quality merchandise at prices lower than elsewhere.

Intellectual Property

The company’s brands include the Costco Wholesale series of trademarks and its private label brand, Kirkland Signature.

Competition

Competitors, such as Wal-Mart, Target, Kroger, and Amazon.com are among the company’s significant general merchandise retail competitors. The company also competes with warehouse club operations, including Wal-Mart’s Sam’s Club and BJ’s Wholesale Club.

History

Costco Wholesale Corporation was founded in 1976.”

FAST Graphs Fundamental Review on Costco: Forecasting EBIDTA and/or Cash Flows

Since a picture’s worth 1,000 words and a video worth many more, I offer the following FAST Graphs fundamental analysis on Costco with a focus on forecasting. This is the fourth in a series of videos I plan to offer on high profile and popular stocks:

Summary and Conclusions

Historically investors had to be willing to pay a premium multiple of earnings in order to invest in Costco.  Although that has historically proven to be a rational strategy, investors should at least be cognizant of the valuation risk they are assuming.  Personally, I’ve never owned the stock because I’ve never found it at a valuation that I felt provided me a margin of safety.  Up to this point, the argument could be made that this has been a mistake.

However, my biggest obstacle has been the ability to apply a rational thesis for paying such a premium valuation.  In truth, I’ve invested in several other companies with equivalent growth rates that I was able to purchase at sound and attractive valuations.  Consequently, I could never rationalize overpaying for Costco.  In that same vein, even though Costco has experienced a double-digit drop in stock price, the company remains valued at a premium even against historical norms.  Consequently, I suggest that prospective investors proceed with caution.  This is a great company, but in my opinion – not a great price.

Disclosure: No position at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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