How often do you hear about buying winning stocks? It often seems simple. For example, big-box retailer Costco Wholesale (COST -0.63%) is what most would call a winner — the stock has created eye-popping total returns of 85,000% over its lifetime, turning a $10,000 investment into $8.5 million.
With such a track record, it’s hard not to simply stuff such proven winners into your portfolio and wait to get rich. But that’s the mistake many investors make — looking backward instead of ahead. That’s why I’ve done the work to look ahead, and here is why Costco could underperform the market, at least in the short term.
Getting too hot to handle
Costco has a lot of fans. For some, it’s the famous $1.50 hot dog and soda combo shoppers love. For investors, the company’s steady growth and durable business model have given shareholders peace of mind for years. I must admit, the chart below is a pretty picture. There’s decades of revenue and earnings-per-share (EPS) growth with nary a blip, aside from the occasional economic crisis.
But what happens when everyone loves the same restaurant in town? Yep, getting a reservation becomes nearly impossible. Enough buyers pile into Costco’s stock, and the valuation is pushed higher. You can see below how that phenomenon has played out — the stock is trading at a price-to-earnings (P/E) ratio of 39, above its average over the past decade.
But it’s arguably worse. The stock’s valuation has drifted higher since the initial COVID-19 market crash, raising the long-term average. If you subtract the past three years and count from 2013 to 2020, the long-term average falls to 25. So the stock today is valued between 22% and 56% over its long-term norms, depending on how you look at it.
Solid (but unspectacular) growth prospects
Now, Costco is still expanding. Sales have averaged 8.6% annual growth over the past decade, translating to 12% annual EPS growth with the help of share repurchases and higher profit margins. That’s solid, and Costco’s ability to do this consistently helps explain the great returns over the years. But the numbers are getting larger and harder to grow, with revenue surpassing $231 billion over the past four quarters.
Analysts also see EPS growth slowing some, averaging 9.5% annually over the next three to five years. Put two and two together, and you’ll see where I’m going with this. The stock is trading higher than its long-term norms, despite growth potentially slowing below its long-term average.
It’s been said that a stock’s fundamentals will eventually drive the share price, and there’s a gap between Costco’s share price and fundamentals that could ultimately close. It’s just a matter of time.
What will that look like?
Some back-of-the-envelope math can paint a picture of the stock’s hypothetical returns over the coming years. For this exercise, I will overshoot some and say that Costco delivers 10% annual EPS growth (just over the estimate) and assume that the company does this for the full five years that analysts are factoring in.
The below chart will illustrate what EPS would look like, starting from Costco’s EPS of $13.14 for fiscal 2022 (ended Aug. 28, 2022):
If the stock were to trade at its decade-long average P/E of 32 in 2027, its share price would be $677 per share, a 31% price gain over five years. That’s an annual rate of return of 5.5%, indeed nothing great. If the valuation retreats to its average from earlier in the decade (remember that P/E of 25?), the resulting $529 makes your stock virtually dead money for half a decade! That’s assuming Costco doesn’t fall short of growth estimates or the market doesn’t put a below-average valuation on the stock at some point.
Remember, this isn’t a science. But these basic calculations show that there might be more risk to investors at this price than the potential reward. Nothing is certain on Wall Street, so investors should look for favorable risk-reward opportunities. Until Costco’s stock cools off, it doesn’t seem like the odds are in your favor.