Costco: Is a luxury valuation of 50 times really a "bubble"?

Through Dolphin Research's analysis of Costco Part 1 and Part 2, we discussed Costco's unique business philosophy of pursuing "less but better" instead of "bigger and broader" and "steady and enduring" rather than "fast-paced" from both revenue and cost/expense perspectives. Under this philosophy, Costco, although not the strongest in terms of growth rate, total number of stores, total market value, etc., demonstrates extremely strong performance certainty across economic/technological cycles and a low-margin high barrier to entry of "even though I move slowly, my competitors can't surpass me."

From a business perspective, Costco is undoubtedly an outstanding company in its industry, as we have elaborated in the previous two articles. However, even good companies need good prices, so Dolphin Research's focus in this article falls on the question: "Is Costco currently a good investment target?"

The following is the main analysis:

I. Is Costco's valuation reasonable?

1. Valuation has soared in recent years, entering a clearly overvalued range

As shown in the chart below, the average PE ratio at the end of each fiscal year from 1999 to 2024 is 27.9x, while currently (end of 24th fiscal year), Costco's PE ratio has reached nearly 55x, exceeding the 2 standard deviations above the average PE ratio for the past 20 years. Historically, Costco has only had such a "sky-high" PE ratio once during the peak of the "dot.com bubble" in 2000. Even during the recent bull market phase in the U.S. stock market over the past 5 years, Costco's current valuation still remains more than 2 standard deviations above the average (40.9x).

From this perspective, Costco's current valuation is undoubtedly quite expensive. So how should we interpret the significant increase in Costco's valuation over the past two years? Can it be mainly attributed to "speculation" or are there "reasonable" reasons behind it?

2. No surprises from the cash flow perspective

What are the common reasons that can explain/support a seemingly significantly high PE valuation?:

The most common explanation - strong profit growth prospects, i.e., PE ratio ≈ future profit growth rate. However, Costco's net profit growth rate has not exceeded 20% over the past decade, and there seems to be no significant driving force for future acceleration. Therefore, a PE valuation of over 50x clearly does not alignAnother common reasonable explanation is that the company's cash net profit is significantly and consistently higher than the financial net profit, that is, although the PE valuation may seem high, the valuation of the company from the perspective of P/free cash flow is relatively reasonable. So, does Costco belong to this situation?

From the cash flow of Costco from fiscal year 2010 to 2024 shown in the chart below, it can be seen that Costco's free cash flow is not significantly and consistently higher than the financial net profit. On the contrary, in most years, Costco's free cash flow is actually lower than the financial net profit. In terms of key items affecting cash flow, Costco's annual amortization and depreciation are generally lower than fixed asset investment, reflecting the continuous capital expenditure demand under Costco's heavy asset model of self-built properties. Moreover, the change in operating working capital did not contribute to continuous cash inflows, indicating that Costco also does not have a continuous situation of funds from the supply chain or consumer accounts receivable. In other words, Costco does not belong to the situation where the valuation from the cash flow perspective is significantly cheaper.

3. Shareholder Returns are also not outstanding

With valuations from the perspectives of net profit and cash flow both "sky-high," then does Costco have any outstanding aspects in terms of shareholder returns to explain such a high valuation?

As shown in the chart below, from fiscal year 1999 to 2024, Costco's market value has grown by nearly 24 times, but the stock price (adjusted for splits) has grown by nearly 35 times. In other words, the returns from holding Costco shares are actually about 46% higher than the total market value increase of the company, which roughly reflects the shareholder returns of Costco shareholders other than capital appreciation since 1999.

Specifically, in the early years (before 2012), the main way of returning value to shareholders was mainly through share buybacks, which were more flexible. Thirteen years later, more stable and predictable dividend payouts became the main method. In terms of return intensity, the average annual shareholder return rate from 2004 to the present is about 3.3%.

However, structurally, in the early years such as 2006 to 2008, as well as in 2013, 2015, and 2017, due to large buybacks or irregular one-time high dividends, the return rate of buybacks + dividends could reach high single digits for a long time. But after 2018, with the normalization of dividends, the overall shareholder return rate has never exceeded 1.5%, even though in 2021, despite the irregular large dividend payout, the shareholder return rate was only 3.5%, mainly because Costco's market value has surged, diluting the return rate. Therefore, in recent years, Costco has not shown outstanding performance in shareholder returns, which is enough to support such a high valuation

Skipping unstable buybacks and abnormal dividends, it can be seen that Costco's normal dividend payout ratio is roughly around 26% to 30%, which is not high. According to the formula for dividend yield = 1 / PE * dividend ratio, Costco's PE multiple needs to be below 30x to have a dividend yield of about 1%, and below 15x to have a dividend yield of around 2%. In other words, unless Costco significantly increases its dividend payout ratio, even if the PE valuation drops significantly, Costco is unlikely to become a true "high dividend stock."

II. Growth Potential Exists, but "Explosive Growth" Comes from a Non-Costco Style

From the analysis above, it can be seen that from a static perspective, Costco's valuation is clearly high in terms of financial report profits, cash flow valuation, and shareholder returns. So, looking dynamically, is there any visible source in the mid-term that can help Costco significantly accelerate its performance growth and gradually digest the current high valuation? In simple terms, Costco operates in the mature offline retail track and follows a "slow and steady" business philosophy, making it unlikely for a sudden acceleration in performance. In the mid-term, potential incremental directions are limited to two points: overseas expansion and online transformation.

1. Overseas Markets

In terms of overseas expansion, Costco began expanding into overseas markets as early as the 1980s, covering approximately 14 countries to date. By the end of the 2024 fiscal year, the number of overseas stores (excluding the U.S. and Canada) was 168, accounting for nearly 19% of the total, showing some achievements. As shown in the above image, the total number of stores in other countries besides the core markets of the U.S., Canada, and Mexico does not exceed a few dozen.

From the perspective of potential incremental space, there are still many countries globally where Costco has not entered, and the store density in countries where Costco has already entered has significant room for improvement if compared to the U.S. and Canada. However, having space does not necessarily mean that Costco has the capability or intention to accelerate the expansion into overseas markets.

Historically, since 2010, except for the year 2011, the number of new stores opened by Costco in non-U.S. & Canada regions has been significantly fewer than the number of new stores opened in the U.S., with no more than 10 stores per year. In other words, Costco prioritizes increasing the density of stores in mature North American markets rather than rapidly expanding into new overseas markets.In other words, the possibility of Costco significantly accelerating its overseas store opening pace to drive performance growth is not high.

2. Online Transformation

Another clear and feasible development direction is online transformation. Although in recent years, the overall growth rate of online retail in the United States has started to rapidly approach that of overall retail, which has not exceeded the average of 5% since the new millennium (excluding automobiles and oil and gas), online retail has still maintained a high single-digit growth rate in recent years, showing relatively high growth potential.

Although online transformation is still considered a growth direction, historically, before the pandemic, Costco's online sales accounted for only about 3% to 4% of the total for nearly a decade, showing no improvement. In 2020, due to the outbreak of the pandemic, Costco was forced to increase its investment in online transformation and acquired Innovel Solutions for $1 billion (a last-mile delivery logistics company) to enhance its fulfillment capabilities needed for online retail. In the same year, Costco's online retail sales proportion jumped to around 6%.

However, the rapid growth momentum of online retail did not continue into the post-pandemic era. Starting from the 2022 fiscal year, Costco's online sales growth quickly fell to below 20%. The proportion of online retail also once again entered a bottleneck period (around 6% to 7%). Costco's online retail business, while small in scale (accounting for less than 10% of the total), also lacks explosive growth potential (growth rate not exceeding 20%). Therefore, although it has the ability to drive overall revenue, it is relatively limited.

Combining the above two points, it is clear that while the overseas market and online retail are both viable and promising growth directions, it can be seen that Costco's focus is still on the domestic North American market and offline retail, without showing signs of relying on overseas and online markets to boost growth. Moreover, Costco's management philosophy is to focus on core business and not to pursue rapid expansion, making it difficult for Costco's performance to achieve explosive growth from the start.

III. Performance Forecast and Valuation

In conclusion, Dolphin Research has explored cash flow, dividends + stock dividend returns, and significantly accelerated growth prospects through the process of elimination, which are the most common reasonable explanations that can support significantly higher valuations. However, for Costco, none of the above seems to hold true. In the end, we can only rely on quantitative analysis to see what kind of expectations are reflected behind Costco's current valuation

1. Earnings Forecast

In terms of earnings forecast, Costco's business model is relatively simple. The revenue side is mainly influenced by two key indicators: the number of new store openings and the same-store sales growth of existing stores. Specifically, the pace of new store openings depends on the company's guidance and is not easy to predict in advance. However, historically, the pace of new store openings has been stable without significant fluctuations.

Regarding same-store growth, it is expected to be similar in fiscal years 25 and 24. In an environment of high interest rates and a slowdown in the macroeconomy, sales growth may slightly slow down or remain low in fiscal year 26 before returning to normal.

In terms of membership revenue, the company announced a $5 increase in subscription fees for regular members and a $10 increase for business and executive members starting in fiscal year 25. Therefore, there will be a significant increase in membership fee revenue for that year. However, based on the pace of price increases once every 6-7 years in the past, there should not be a second increase in membership fees during the forecast period, and growth will return to stability.

As for profit, due to the company's active control, the gross profit margin is unlikely to show a trend change. The forecast for operating costs is related to the total area of operating stores. Therefore, as long as the growth rate of sales per square foot exceeds the growth rate of operating costs per square foot, Costco's profit margin will continue to increase slightly. However, as a mature business, the expense ratio will not fluctuate significantly. For specific forecasts, please refer to the chart below.

2. Quantitative Valuation Analysis

Firstly, from a comparative valuation perspective, we have selected Walmart and Home Depot as comparison objects, as they are both leading companies in the retail industry with similar business models. On the other hand, we have also selected several companies that are absolute leaders in their respective industries, with significant competitive advantages and high performance certainty.

As shown in the table below, Costco has a significant premium in the retail industry. While the expected profit growth rates in the next two years are generally similar, Costco's PE valuation is about 40% higher than Walmart's.

Even when looking across industries, Costco's valuation is higher compared to most of the leading companies we have selected in the retail sector. It can be seen that only two luxury leaders, Hermes and Ferrari, have valuation levels similar to Costco, both around 40x to 50x.

After adjusting for performance growth rates, the PEG indicators of Costco, Hermes, and Ferrari are all "coincidentally" above 5x, except for Home Depot due to abnormally low profit CAGR.

Therefore, it can be seen that the market's perception of Costco is to some extent similar to top luxury brands. There are indeed similarities between the two, such as targeting a narrow range of high-quality customer groups, limited and slow-growing supply, and high bargaining power for merchants over customers (or high customer loyalty) Wait a minute. In this way, Costco is indeed expensive, but other companies with top-notch models are basically equally expensive, and Costco is not an exception.

3. Absolute Valuation

In terms of absolute valuation, we use the DCF method. Due to Costco's extremely high performance certainty, and a low beta coefficient, we calculated a WACC of 7.62%, which is a relatively low number.

The key difference in expectations lies in the judgment of the long-term perpetual growth rate,

1. Generally, we use a perpetual growth rate of 2%, roughly equivalent to the steady-state GDP growth rate of the United States. This means that over a time scale of more than 20 years, Costco's profit/cash flow growth rate will gradually decline to 2%. In this scenario, we calculate Costco's per share price to be $480, corresponding to a 25-year net profit equivalent to a 27x PE ratio. There is a significant difference compared to the current stock price, but it also aligns with Costco's historical average valuation.
2. However, one of Costco's special features is its stable growth across cycles. After all, the demand for consumer goods and daily necessities is perpetual. As long as offline channel share does not significantly decline. Costco, which has generally maintained a growth rate of over 10% in the past 20-30 years, slipping to a 2% growth rate in the next 20-30 years may indeed seem too low. What is a reasonable high perpetual growth rate? This question is also difficult to judge a priori. However, reverse deducing from the current valuation, based on our assumptions, the implied requirement for Costco's perpetual growth rate in the current price is approximately between 5% to 5.5%. In this light, expecting Costco to maintain a profit growth rate of 5% or more for the next 20-30 years or even further into the future does not seem far-fetched, and is achievable.

Combining the relative and absolute valuation methods, it is evident that Costco's valuation is indeed expensive, which cannot be denied. However, when viewed horizontally, other companies with top-notch business models and performance certainty do not have lower valuations than Costco. From an absolute valuation perspective, as long as Costco can maintain a profit/cash flow growth rate of 5% in the long term, the current valuation can be supported.

In other words, while Costco's valuation may be expensive, there is also quantitative data to support the argument for more funds. Therefore, even if we believe there is a certain bubble, it cannot be asserted that there will be a "dive-style" drop to squeeze out the excess.

A more appropriate statement is that the implied value for the current price is significantly undervalued, and in the medium to short term, even if the PE ratio remains above 50x without falling back, investors will have a return of around 10% profit growth rate annually, which will outperform the 9% capital market required return, without excess returns.In the long run, the rate of return that can be earned by buying at the current price depends on the extent to which Costco's perpetual profit growth rate exceeds 5.5%. Unfortunately, the potential upside seems to be very limited.**

Dolphin Research's previous studies on [Costco]:

September 10, 2024《 Pinduoduo Idol - Is Costco the "Ideal" in Retail? 》

September 27, 2024《 Costco: How does the retail "snail" forge an "indestructible" body? 》