Costco Wholesale (NASDAQ: COST) has been a huge winner for investors over the long term. Since 2000, the stock has risen nearly 1,700%. Its total return for that period, which assumes reinvested dividends, comes in at 2,500%! Those massive gains are backed by a solid business that just recently announced a new catalyst for growth.
But if you buy shares today, you should prepare yourself for the possibility of a deep drawdown at some point over the next three years. Here’s why.
The Costco model
Costco has two primary revenue streams. As a retailer, the first is fairly obvious. It sells products in its stores and online. In the fiscal third quarter of 2024, product sales tallied up to nearly $57.4 billion. The costs associated with those sales, however, are significant. Specifically, it has to buy the products it sells, generally known as the cost of goods sold (Costco calls it merchandise costs). This expense was about $51.2 billion. Subtract that from sales and you get $6.2 billion.
But there’s more on the income statement that you need to consider — namely, the company’s selling, general, and administrative expenses. These are the costs that Costco has to pay to run its global store network. SG&A expenses were roughly $5.1 billion in the fiscal third quarter. Subtract that from the $6.2 billion noted above and you come up with a profit from the company’s stores of around $1.1 billion.
This is where things get interesting, because Costco uses a club model and customers have to become members to shop there. The membership fees that customers pay to shop at its stores have very little cost associated with them, so they really drop right down to profits. Membership fees in the fiscal third quarter were a touch over $1.1 billion. The company reported operating income of around $2.2 billion, of which roughly half came from membership fees, with store operations accounting for the rest.
Costco just announced that it is lifting its fees from $60 per year to $65 for regular members and from $120 to $130 for executive members. Those jumps represent an 8.3% price boost in both cases that will flow directly to operating income. It will take at least a year for the price increase to roll out, since customers join throughout the year and, thus, have different anniversary dates. However, Costco has clearly set the stage for more growth ahead on top of whatever it achieves on the retail side of things.
The big problem with buying Costco stock
Wall Street is well aware of the strength of Costco’s membership business model. It knows that revenue has grown at an annualized rate of nearly 9% a year over the past decade, and earnings have expanded by nearly 12% annually during that time frame. That’s why the stock has risen so dramatically. The question is: Where to from here? The answer may not be so great.
Right now, Costco is sporting a price-to-earnings ratio (P/E) of roughly 50. Its five-year average P/E ratio is just under 40. The current P/E ratio is not only 25% above the average for the stock, but it also happens to be near the highest levels in the company’s history. Simply put, Costco is a good business, but it is also an expensive one to own today.
The thing is, if you look at the long-term stock graph, it seems like a fairly smooth run upward over time. But if you change the lens and look at the price drawdowns over time, you’ll notice that Costco investors have often experienced declines of 20% to 40% (or more). The current pullback is only about 8% or so. That’s probably not a great buying opportunity given the lofty P/E ratio.
In fact, given the extreme valuation being afforded Costco today, along with the stock market trading near all-time highs, it seems highly likely that there will be a bigger share-price slump at some point in the next three years. That could be unique to Costco, or it could come along with a broader bear market in which investors tend to dump the stocks that were once most favored.
It’s not shocking for a fast-growing company to see big drawdowns, but it is something that investors need to at least be prepared to live through if they buy Costco shares today.
Probably best to wait on Costco
Even a great company can be a bad investment if you pay too much for it. That wisdom comes from Benjamin Graham, the man who helped train Wall Street icon Warren Buffett. It looks like this applies to Costco today. Patient investors will probably be rewarded with a better buying opportunity in the next three years given the lofty valuation Wall Street is affording the warehouse giant right now. And if you own the stock, don’t be surprised if the there’s more downside from here.
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Reuben Gregg Brewer has 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.
Where Will Costco Stock Be in 3 Years? was originally published by The Motley Fool
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