Costco (COST 0.88%) is a store I frequent almost weekly, thanks to the good prices and the shockingly fresh produce. That said, I’ve never owned the stock, even though it has the type of impressive dividend record that attracts my attention. Sometimes I wish I had bought it, though, because paying full price for a great company can often lead to strong returns. But what about buying it today? Would adding Costco to your portfolio right now set you up for a lifetime of strong returns?
Costco’s business model is strong
The first thing that investors have to get their heads around when it comes to Costco is the business. It is not your typical retailer — it is a club store. Customers, like me, pay a yearly fee for the privilege of shopping at Costco. Those membership fees, which basically have no costs associated with them, make up around half of the retailer’s operating income. That changes the retail game in a very important way.
Image source: Getty Images.
Basically, Costco looks at its business in a totally different way because it isn’t earning all of its money from product sales. Thus, keeping customers happy becomes the core objective, so it can keep those membership fees rolling in. The three primary ways it does this is by having cheap prices (membership fees allow it to accept lower margins), creating an enjoyable shopping experience, and having a great selection of products. The long-term success of the business tells you that it has succeeded quite well overall.
The numbers speak for themselves. Over the past decade, revenues have grown at a compound annual rate of around 8.5%, while earnings have expanded at a 13.5% clip. As noted, the dividend has been increased every year for two decades, with the past decade’s annualized dividend growth a very impressive 12%.
Costco is the kind of retailer you’d want to own, but…
I’m leery of retail stocks because, in general, retailers tend to go in and out of favor. When people move on to a different retailer, the financial effect on a now out-of-favor retailer can be very hard (think bankruptcy). It’s why I prefer to own retail-focused real estate investment trusts (REITs), which can collect rent no matter what retailer occupies a well-located property. But Costco is one of those retailers that has bucked the trend because of its strong business model. The problem is that Wall Street knows just how good the company is, and it doesn’t go on sale very often.
COST PE Ratio data by YCharts.
That’s why investors looking at Costco will probably want to keep it on the wish list and not the buy list today. Using traditional valuation metrics is all you need. The price-to-sales ratio is around 1.6x today, versus a five-year average closer to 1x. The price-to-earnings ratio is 56x right now, versus a longer-term average that is just under 41x. Its price-to-cash flow and price-to-book values are both notably above their five-year averages, too. The dividend yield, my preferred valuation tool, is a tiny 0.5%, compared to a five-year average of around 0.7%.
Almost any way you cut it, Costco is an expensive stock today. To be fair, I expect Costco to look expensive relative to the broader market just about all the time. The problem is that Costco looks particularly expensive relative to its own history right now. To paraphrase famed value investor Benjamin Graham, paying too much for a good company can be a bad investment.
The current call on Costco
Overall, Costco is a very well-run company with an advantaged business model. There are a lot of things to like about it, and it should probably be on most investors’ wish lists. But right now, given the lofty valuation, it probably shouldn’t be on your buy list. Buying it at the right price could set you up for life … overpaying just to own it could leave you with “dead money” for years to come.
