Costco Stock: Long Road To $300

I’ll cut to the chase: It should take ten to fifteen years for Costco stock (CSCO) to reach an earnings level that would justify a price of $300 per share, roughly double the $149 price of Costco stock that existed as of Friday’s close.

Considering that Costco stock only offers a starting dividend yield of around 1%, I assume that most people own Costco stock because they want it to give them strong capital appreciation.

That makes me pose the question: What business results would be necessary for this stock to legitimately double in value?

Because Costco has such strong relations between management and labor, has an unusually strong balance sheet of $4 billion in cash and only $5 billion in debt, earns “free” income through its membership renewals, and has a demonstrated history of 8-10% annual earnings growth, I am willing to accept the premise that Costco stock will have a long-term P/E ratio of 20 compared to the grocery industry average of 14-16. Premium balance sheets, history, and business execution justify a higher valuation.

The next question is: At what level of earnings would Costco justifiably trade at a price of $300 if its fair value is 20x earnings? The answer is that Costco would earn $15 per share in net profits for the stock to fairly trade at $300.

The problem? Current earnings are only at $5.50. To get there in ten years, Costco would need to grow earnings at 10.55% annually. To get there in fifteen years, Costco would need to grow earnings at 6.92% annually.

Recently, I wrote IBM and argued that IBM gets misjudged based on its poor history of recent performance, as some people don’t realize how much the P/E ratio has shifted to give today’s investors in the stock a much better starting point than the investors of five years ago received.

Costco is the flip side of that argument. It is an example of a well-run company demonstrating excellent recent returns which has probably caused some Costco shareholders to neglect the fact that the valuation has gotten way ahead of itself. In the past five years, Costco has delivered 16% annual returns. But the earnings only grew by 9%. About half of Costco’s gains have come from an expanding P/E ratio.

The valuation of Costco in 2011 already seemed high enough at 21x earnings. Since then, the stock has climbed to the 27-28x earnings range. This is not sustainable for a wholesale grocer. Especially when the valuation already hovers towards the $70 billion range.

The stock is about 25% overvalued. It should trade at $110 rather than $150. As a consequence, you are going to see future stock performance lag earnings growth for a bit while the P/E compression works itself out. Costco stock shouldn’t be worth $300 per share until the 2026-2031 range.

If I held Costco in a taxable account, I would not sell here because I don’t think the overvaluation is substantial enough to warrant the wealth forfeiture via the capital gains tax. If it were in a tax-advantaged account, I’d be much more open to selling it. Even though it probably “feels weird” given the radical differences in recent five-year performance, I imagine that trading in Costco stock for Viacom stock would lead to superior compounding over the next decade. If I were contemplating an investment in Costco, I would need to see the stock fall $30-$40 before I got interested.

It does not make sense to value a $70 billion grocer at 27x earnings. The valuation level of 2003-2007 when the stock traded at 20-21x earnings was much more rational. That’s a 25% bit of price compression that is required for the stock to return to a fair price. Costco is an excellent company, but the 2011-2015 shareholders already gobbled up more than their fair share of returns that are merited by Costco’s earnings growth. To restore equilibrium, the new shareholders will have to receive less than their fair share. When it all shakes out by the 2030 range, I imagine the 2016 Costco shareholders will have to subtract about three percent annually from the business performance results of the firm. That is to say, if Costco grows by 9.0% annually for the next ten to fifteen years, the shareholders themselves will see capital appreciation of 6.0% annually.