With Costco (NASDAQ: COST) shares commanding more than a 56 price-to-earnings multiple at the time of this writing (more than double the S&P 500's multiple of about 24), it's fair to say that investors love the stock. Of course, Wall Street's love affair for the membership-based wholesale retailer's shares isn't surprising. Not only is Costco a great business growing at robust rates, but it provides investors with growing dividend income.
Still, even a great business can become a bad stock if its shares become overvalued. Has Costco stock reached this point? More specifically, let's explore whether the stock is a buy, sell, or hold today.
Recent performance
Recently wrapping up its fiscal year, Costco announced earlier this month that its total sales for the period rose 5% despite the fiscal year having one less week than the prior period. This was driven by growth in its global store count and an increase in comparable sales.
Costco's comparable sales for the 52-week fiscal year ended Sep. 1 rose at robust rates in each of its three operating regions. In the U.S., Canada, and its remaining international stores, the key metric saw growth of 4.5%, 7%, and 8.1% year over year, respectively. Further, Costco's e-commerce sales for the fiscal year rose 16.1% year over year, with growth accelerating toward the end of the period (e-commerce sales rose 22.9% year over year in the four-week fiscal month ended Sep. 1).
Combining this strong momentum in net sales with Costco's recent announcement that it increased its annual membership fees starting Sep. 1, there's good reason to expect the company's net income to grow even faster than these recent sales growth rates. This is because Costco's membership fee revenue virtually all falls down to the company's bottom line.
Costco's valuation may be too rich
The problem with Costco stock, however, is that a price-to-earnings ratio of 56 arguably already prices in the company's long-term growth prospects. Looking at the valuation from another angle, consider that Costco's $7.2 billion in trailing-12-month net income amounts to just 1.8% of the company's $403 billion market capitalization at the time of this writing. This low earnings yield puts the spotlight on how fast Costco will have to grow its bottom line to live up to investors' high expectations.
Selling could be a mistake
But a rich valuation doesn't automatically make a stock worth selling. Investors who own Costco shares may not want to sell for several reasons. First of all, many of them are likely sitting on large unrealized gains. Selling, therefore, could represent a significant taxable event for some investors. Second, because the overall market seems richly valued at the moment, investors may not have better ideas as to where they will deploy any cash they get from selling Costco shares. And one final reason not to sell: Though shares are overvalued, they are not grossly overvalued. In other words, even at Costco's current stock price, a case can still be made for a mid-single-digit annualized return over the long haul. Though this would be far below the stock's returns historically, it's still a notable positive return. Further, sometimes holding onto great companies at valuations that seem stretched makes sense because it gives the company a chance to exceed an investor's expectations.
All of this to say, the stock looks like a hold today. But given Costco shares' high valuation, shareholders who choose to hold the stock should be prepared for some big drawdowns at some point in the future. Though no one knows what the future holds, it's better to be prepared for a bumpy ride than to unrealistically expect more of the steady up-and-to-the-right that the stock has rewarded investors with recently.
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Daniel Sparks and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
