The Profit Puzzle
For years, Costco has been revered as both a company and a stock, outperforming the S&P 500 with a staggering 118,000% return since its inception as a public company 38 years ago. However, new investors should exercise caution in 2024 due to an underlying issue that poses a potential threat to short-term investment returns.
Costco’s Hidden Revenue Stream
At first glance, it seems that Costco derives its profits solely from selling goods. But there’s a secret sauce behind the scenes. Membership fees have proven to be a lucrative contributor to Costco’s bottom line, raking in $1.082 billion in the first quarter of fiscal 2024—an impressive 8% increase year over year. The high-margin nature of membership fees has fueled the company’s consistent earnings growth and exceptional investment returns.
The Popularity Predicament
Costco is undeniably the “cool kid” everyone wants to be friends with—the stock every investor dreams of owning. Its popularity is at an all-time high, reminiscent of the dot-com stock market bubble in the late 1990s. However, issues arise when a stock’s valuation exceeds the company’s actual performance. The market must see tangible results that justify the lofty valuation; otherwise, it will no longer be willing to pay such a premium.
Challenges Ahead
Costco operates in a lukewarm business climate impacted by rising prices of consumer goods and services. These headwinds pose a potential obstacle to Costco’s earnings growth. Analysts have adjusted their long-term earnings growth estimates to a modest 8% annualized rate. Furthermore, the stock is currently trading near its all-time high, with a price-to-earnings ratio (P/E) of 44 based on estimates for Costco’s fiscal year ending in August. Looking forward, the stock’s price-to-earnings growth (PEG) ratio exceeds 5, indicating a relatively high valuation compared to projected growth.
In general, a PEG ratio below 1.5 is considered favorable. Viewing Costco’s valuation through this lens, it appears expensive relative to analysts’ earnings growth expectations. While the stock’s price could experience a significant decline, or earnings growth could surpass expectations, caution is advised when considering its current price point.
To put it simply, Costco stock’s valuation feels like a runaway train. Although it remains a fantastic company and a worthwhile long-term investment at a reasonable price, jumping on board at these levels may result in a bumpy ride.