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Costco Is Expensive but it May Be Worthwhile

Mark R. Hake
·4 mins read

Costco (NYSE:COST) stock is up just 15.7% so far this and up 24% in the past year. Most of its peers have done better, but Costco stock is much more expensive. Something doesn’t make sense here. This article looks at the relationship between Costco’s higher valuation and its relative returns.

Short-Term Profit Taking May Take a Bite out of the Costco Stock Price
Short-Term Profit Taking May Take a Bite out of the Costco Stock Price

Source: Helen89 / Shutterstock.com

For example, Amazon (NASDAQ:AMZN) is up 72% year-to-date. And it increased over 77% in the past year. These are both significantly higher returns that Costco stock. However, Target (NYSE:TGT) is up 7.8% in 2020, but over 64% in the past year. The year-to-date is lower than Costco but the one-year return is higher.

Walmart (NYSE:WMT) stock is up 14.1% year-to-date, slightly lower than Costco. And its one-year return is up 20%, also lower than Costco. Lastly, Kroger (NYSE:KR) is up 24.2% year-to-date, and 58.9% over one year. Both of these blow away Costco stock’s performance.

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The problem is that every one of these peers, except for Amazon is much cheaper than Costco. Costco sells for 39.6 times 2020 estimated earnings. But Target is at 26.9 times earnings, Walmart is at 26.8 times, and Kroger trades for just 12.7 times earnings. These three are all cheaper by at least one-third or more than Costco.

Only Amazon is more expensive at 100 times earnings. But of course, its performance blew way past Costco.

Why Returns Matter When Fundamentals Rule

We can look at ratios and growth rates and strategy differences and compare them all day. But you see my point. It’s the stock price performance that matters in the end.

The bottom line is this: Costco stock is simply too expensive for its average stock return performance. Why pay a premium, in terms of earnings, just to get an average to poor stock price gain?

If you watch CNBC, or even Fox Business or read online what analysts say about stocks, it’s always about the fundamentals or the expected outlook.

But at some point, don’t you just have to reject this and just look at reality? You say, hey, whathappened in the past and why am I overpaying for this stock?

Well, here is one reason. The long run counts. Costco’s price-earnings ratio is higher than its peers because its formula works better over the long run. The proof? Costco stock outperformed its peers over the past five years, except, of course, for Amazon. Nobody ever beats Amazon.

For example, Costco stock is up 132.7% over the past five years. Walmart is up just 88.6%, Target is up 75%, and Kroger is actually down 6.9% over the past five years. Amazon stock rose by 494.6%.

So, for the most part, Costco stock beat its competitors, except Amazon, by at least 50% to 60%.

What to Do With Costco Stock

Therefore, the moral of the story is that you pay for what you get in the long run. You pay a high price for the higher expected performance over several years. This is clearly evident with Amazon. But it is also clear with Costco stock.

For example, Costco’s P/E ratio is one-third higher than its peers, but in the long-run – at least five years – the return is twice that higher P/E. In other words, the average 65% higher performance is twice the 33% higher P/E ratio.

So, sometimes, all you have to do is look at the simplest numbers, not the fundamentals. The fundamentals work themselves out over the long run. Costco’s superior fundamentals translate into superior performance, despite the higher price the market charges for the stock.

The only important requirement is time. It takes time for the market to works these things out and see the value of the higher quality of the company.

That means if you want to buy Costco stock, stick with it for a good five-year period. You can average cost into the stock over this time. That will help you to be patient investing in Costco stock over time.

As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. He runs the Total Yield Value Guide which you can review here.

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