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Should You Be Tempted To Sell Costco Wholesale Corporation (NASDAQ:COST) Because Of Its P/E Ratio?

Simply Wall St

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Costco Wholesale Corporation's (NASDAQ:COST) P/E ratio could help you assess the value on offer. What is Costco Wholesale's P/E ratio? Well, based on the last twelve months it is 37.02. That corresponds to an earnings yield of approximately 2.7%.

See our latest analysis for Costco Wholesale

How Do You Calculate Costco Wholesale's P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Costco Wholesale:

P/E of 37.02 = $303.76 ÷ $8.2 (Based on the trailing twelve months to May 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

Does Costco Wholesale Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Costco Wholesale has a higher P/E than the average (21.5) P/E for companies in the consumer retailing industry.

NasdaqGS:COST Price Estimation Relative to Market, September 9th 2019

That means that the market expects Costco Wholesale will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Costco Wholesale increased earnings per share by an impressive 20% over the last twelve months. And its annual EPS growth rate over 5 years is 13%. So one might expect an above average P/E ratio.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

Costco Wholesale's Balance Sheet

The extra options and safety that comes with Costco Wholesale's US$2.1b net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On Costco Wholesale's P/E Ratio

Costco Wholesale's P/E is 37 which is above average (17.5) in its market. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. Therefore it seems reasonable that the market would have relatively high expectations of the company

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.