One Bargain You Can’t Find at Costco Is Its Stock—Does That Matter?
Investors love Costco so much they’ll pay more for it than Nvidia. But even famed investor Charlie Munger might balk at his favorite retailer’s earnings multiple today.
In an interview last year, Warren Buffett’s late right-hand man observed that the “trouble with Costco” is that the stock trades at 40 times earnings. “Except for that, it’s a perfect damn company, and it has a marvelous future,” he said.
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Since then, Costco’s valuation has expanded even further: It fetches nearly 55 times trailing-12-month earnings. That makes it the most expensive retail stock in the S&P 500—about 60% above the industry average and 29% pricier than runner-up Amazon. Most impressive is its slight premium to red-hot chip maker Nvidia, which is expected to grow its earnings per share about three times as quickly as Costco over the next five years.
Some investors treat Munger’s comments as holy writ, but read them carefully. While he has said he would never sell his Costco shares, he didn’t say he would buy them at any price. His estate has about $167 million worth of its shares. Most of those were bought in 1999 and 2000, when the stock averaged 36.5 times trailing-12-month earnings. If an investor had followed Munger’s footsteps and bought $1,000 worth of Costco shares about 24 years ago, they would be sitting on more than $27,000 today—more than double what an investment in Berkshire Hathaway would now be worth and more than six times the S&P 500’s return.
Those eye-watering gains are enough to induce a nasty case of FOMO. Yet Costco’s much higher multiple today means investors face a very real risk of mediocre returns. Consider the so-called Nifty Fifty stocks that rallied in the early 1970s: They were touted as “one decision” stocks to buy and hold because of their proven growth track records and consistent increases in dividends, according to a 1998 paper by Wharton finance professor Jeremy Siegel, author of “Stocks for the Long Run.”
This group of highly-regarded companies, on average, sported a multiple of 42 times earnings at the market peak in December 1972 compared with a 19 times multiple for the S&P 500. They include some household names such as Coca-Cola, Pfizer, Walt Disney and McDonald’s. As a group, the Nifty Fifty performed only slightly worse than the S&P 500 over the 26-year period tracked by Siegel. But none of the 11 most expensive stocks on that list—those commanding multiples of 50 times or more—beat the S&P 500’s returns over the period. As a group, the priciest stocks yielded an average annualized return of 5% compared with the S&P 500’s 12.7%.
That isn’t to say expensive stocks never pay off: In fact, Siegel concluded that some companies—including Philip Morris and Eli Lilly—should have commanded earnings multiples higher than 50 times back in 1972 based on their future returns. But that select group, on average, increased their earnings per share at a remarkable 14.3% annual rate for 24 years.
Some investors might say that Costco also deserves a premium for its consistency, and they would have a point. The retailer’s same-store sales have risen every year since 2000, a record that only two other retailers in the S&P 500—O’Reilly Automotive and Kroger—have matched. And, crucially, Costco has delivered a return on invested capital exceeding 10% in almost every year since 1998. Companies that can reinvest their retained earnings at such attractive rates are called compounders, and they are among the best-performing stocks in history.
Costco has a simple but seemingly indestructible business model that no other retailer has been able to replicate. The company keeps operating costs low by running no-frills warehouses with a limited number of products displayed on pallets in large quantities. The limited number of stock-keeping units—typically less than 4,000 per store—helps Costco gain better negotiating leverage with suppliers and allows it to turn over inventory a lot faster, helping keep working capital down. And Costco frequently switches out items available at its stores, giving visits a “treasure hunt” appeal.
Membership fees aren’t cheap. Members can quickly recoup them though, because Costco keeps its markup low. Gross margins of 12% to 13% are about half of Walmart’s. And it stubbornly clings to margin-eroding but popular deals—such as the $1.50 hotdog-plus-soda combo and the $4.99 rotisserie chicken—to keep members happy. The numbers speak for themselves: Membership renewal rates have only increased over the years. They hit 93% in North America last year, and 90% globally.
Costco has been able to keep expanding steadily both through growth in existing stores and a 2% to 3% addition in new stores a year, both in North America and abroad. One question is whether the retailer can keep growing at the same pace over the long term. Costco now has more than 850 stores globally, a third more than it operated a decade ago.
Bulls would say there is plenty of white space: BMO Capital Markets estimates that there is enough untapped potential in the U.S. for Costco to open clubs at the current pace of about 14 clubs a year for another 16 or more years. Costco’s popularity abroad suggests the retailer might also have a long runway internationally.
But there is a price for everything. Assuming Costco’s earnings per share grows at a generous 13% annually over the next five years, as Wall Street expects, its shares—at today’s price—would still be trading at a roughly 30-times multiple in 2029, somewhere between Microsoft and Coca-Cola’s current multiple. And is it possible that another company could come up with a retail format even more compelling than Costco? It is hard to imagine now, but disruptions can happen in any industry—even dusty-old retail.
In much the way that prospective Costco members debate whether the membership fee is worth it, investors should think carefully about the company’s steep sticker price. At today’s prices, they might want to consider shopping elsewhere.
Write to Jinjoo Lee at jinjoo.lee@wsj.com