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Why Costco stock is seemingly forever priced for perfection: Morning Brief

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Monday, December 5, 2022

Today's newsletter is by Brian Sozzi, editor-at-large and anchor at Yahoo Finance. Follow Sozzi on Twitter @BrianSozzi and on LinkedIn. Read this and more market news on the go with Yahoo Finance App.

Seven years into retirement as a stock analyst, I can confidently say these two things: One, I don’t miss building multi-factor models in Excel; and two, I do sometimes miss covering Costco’s stock.

Costco, hands down, was one of my favorite stocks to provide client coverage on. I always knew what I would be getting from management: clear, concise guidance on earnings calls married with stellar and consistent real-world execution.

If I had questions, I could just go inside a local Costco to grab a $1.50 hot dog combo and analyze, analyze, and analyze some more.

A particularly interesting aspect to covering Costco — Yahoo Finance's "Company of the Year" for 2022 — was the stock’s valuation. For as long as I have been studying Costco’s stock — let’s go with 18 years — it has always traded on valuation multiples that were well above the S&P 500 and peers such as Target and Walmart. In other words, Costco’s stock is perpetually stuck in a land of priced for perfection.

What made that tricky is that Costco could post a blowout monthly sales number and the stock would get whacked “just because” a few analysts wanted MORE of a blowout.

Present day is no exception.

Costco’s stock got slammed by 7% last Thursday and screamed to the top of our Top Trending Tickers page because November sales excluding gas and foreign exchange impacts only rose 5.3%. In October, sales rose 6.7%.

The month to month sales slowdown isn’t going to cut it for a stock trading on a forward P/E multiple of 36 times, according to Yahoo Finance data. On the other hand, the S&P 500 is trading on a forward price-to-earnings multiple of 19 times.

So why is Costco’s stock seemingly forever priced for perfection? A couple things to acknowledge that I think will be useful in your analysis of other companies:

  • Costco has a recurring revenue stream in the annual amount people pay to be a Costco member. Wall Street will tend to assign a higher P/E ratio to those companies that have recurring revenue streams as it provides a margin of safety — see Apple and any software-as-a-service company. When Costco inevitably raises membership fees in 2023, sit back and watch the stock take off as this high margin revenue stream becomes even more of a profit tailwind.

  • Costco is viewed as a better, more consistent operator relative to pure rivals such as BJ Wholesale and Sam’s Club. Looked at another way, you want to pay more to own a stock of a company that over time outperforms its peer set fundamentally.

  • Costco is a cash cow, in large part due to the cash flow from its aforementioned recurring memberships. Costco has historically plowed that excess cash into opening more new clubs to generate more high margin membership fee income. It’s a virtuous cycle.

A general view of the Costco Warehouse, in the suburb of Westgate, on August 25, 2022 in Auckland, New Zealand. (Photo by Phil Walter/Getty Images)
A general view of the Costco Warehouse, in the suburb of Westgate, on August 25, 2022 in Auckland, New Zealand. (Photo by Phil Walter/Getty Images)

Having said all of this, it’s reassuring to know that analysts still in the game today continue to wrestle with the great valuation debate on Costco.

“The valuation does give some people some angst because they are at such a big premium to the market," Goldman Sachs retail Kate McShane told me. "They're at such a big premium to Walmart and other big box retailers that some people don't totally understand it or they can't really bridge the gap between them. Sure, we know Costco is a great retailer, but should they be at a 10 turns higher valuation [PE ratio] than Walmart?”

Cheers to no more discounted cash flow analysis. Happy Trading!

More Yahoo Finance Company of the Year 2022 coverage:

What to Watch Today

Economy

  • 9:45 a.m. ET: S&P Global U.S. Services PMI, November final (46.1 expected, 46.1 during prior month)

  • 9:45 a.m. ET: S&P Global U.S. Composite PMI, November final (46.3 during prior month)

  • 10:00 a.m. ET: Factory Orders, October (0.7% expected, 0.3% during prior month)

  • 10:00 a.m. ET: Durable Goods Orders, October final (1.0% during prior month)

  • 10:00 a.m. ET: Durables Excluding Transportation, October final (0.5% expected, 0.5% during prior month)

  • 10:00 a.m. ET: Non-defense Capital Goods Orders Excluding Aircraft, October final (0.7% during prior month)

  • 10:00 a.m. ET: Non-defense Capital Goods Shipments Excluding Aircraft, October final (1.3% during prior month)

  • 10:00 a.m. ET: ISM Services Index, November (53.3 expected, 54.4 during prior month)

Earnings

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