We believe that Costco (NASDAQ:COST) is a medium quality company with a Business Quality Score of 4 based on a scale of 1 to 10 (10 is best). Also, shares of Costco appear to be overvalued based on a discounted cash flow analysis. Costco's stock would need to fall 41.9% to reach fair value based on the closing price of $102.02/share for Costco shares on 02-14-2013.
Business Quality Analysis:
Costco has a Business Quality Score of 4 out of 10 based on an analysis of historical data. We assign a Business Quality Score to each company undergoing analysis. The score is based on a scale of 1 to 10 with a value of 10 indicating the best possible Business Quality Score. Our Business Quality Score is a proprietary metric which takes into account the 10-year historical performance of the company. Performance is measured considering the absolute performance (and trends) in revenues, earnings, profit margins, and returns on assets/equity.
Low Business Quality Scores (3 or lower) indicate companies that are in a cyclical or commodity business. These businesses have erratic revenues and earnings with associated low profit margins and poor returns on capital. Low quality companies operate in highly competitive/cyclical businesses where consistent profits are nearly impossible to achieve.
Medium Business Quality Scores (4 to 6) indicate an average quality business that operates in a business environment that is not overly cyclical in nature. Also, the products or services these businesses provide are not yet commoditized but do operate in a highly competitive business environment. Moreover, these businesses do not have durable competitive advantages that will allow these businesses to earn consistently high returns on capital. Companies with a medium Business Quality Score can sometimes be good investments if bought at deeply discounted prices and sold at fair value. This is in contrast to investments in businesses with high Business Quality Scores where paying fair value for shares can yield good returns if held for the long term.
High Business Quality Scores (7 or higher) indicate companies that are in high quality businesses with some type of durable competitive advantages that keep competitors at bay. These businesses typically have steadily rising revenues and earnings with associated high profit margins and high returns on capital.
Costco's revenues have preformed reasonably well over the last 10 years growing at an annualized rate of 8.8%. Revenues increased every year over the past decade except 2009 (down 1.5%), which is most impressive. We believe future annualized revenue growth will continue at an easily achievable 8% rate over the next 10 years.
Earnings Per Share:
Costco has grown earnings over the last decade at an annualized growth rate of about 9.8%. This is a reasonable growth rate which we believe will continue in the future. A company's earnings per share is a measure of profitability for a company. The earnings per share is calculated by dividing the net income attributable to the common stock by the average number of common shares outstanding. One drawback in using earnings as a profitable measure is that it does not consider the amount of assets needed to generate the earnings. Earning the same profit using fewer assets is more profitable but this is not captured in the earnings per share calculation.
High quality companies will have steadily rising earnings that do not vary greatly through a full business cycle (expansion-recession-expansion). Investing in high quality companies is fairly easy assuming an investor has realistic profit expectations and has the patience to wait for a reasonable stock price relative to the company's value.
Lower quality (cyclical) companies will have earnings that vary greatly over a business cycle. Often these cyclical companies will experience a drastic reduction in earnings during economic recessions. Investment profits can be had with investments in cyclical companies but the timing of the buying and selling of the investment must be in sync with the ebb and flow of the stock market. Typically, the stock market will start to recover about 6 months before the economy comes out of recession. However, this point in time is not obvious at the moment and is only known later with the benefit of hindsight. Furthermore, timing when to sell a cyclical stock is even more difficult. Timing the stock market is a matter of luck so it is best to stick with the higher quality stocks where market timing is not as critical to investing success.
Net Profit Margin:
Costco has had very consistent net profit margins in the range of 1.5% to 2.0% over the last decade. However, these profit margins are very low even for a retailer. For example, Wal-Mart's net profit margin usually runs at about 3.6%. Ideally, we would like to see Costco's net profit margins double what they are today. The net profit margin is net income divided by net revenues. For non-retailing companies, a consistent net profit margin of 9% or higher is an indicator of a good company with some type of durable competitive advantage. In the retail sector, a net profit margin in the range of 2.5% to 5% is the norm even for the best companies. Ideally, the net profit margin should be steady or rising over the past 10 years.
Return On Assets:
Costco has had a return on assets in the range of 5.1% to 6.7% over the last decade. Costco's performance in this regard is not impressive. Never in the last 10 years has the return on assets been above the critical 7% level. We expect the return on assets to hover around 5.5% in the coming decade. Return on assets is a measure of how much profit is generated from a company's assets independent of how much debt is used to finance the acquisition of those assets. The return on assets is sometimes a better measure of profitability than return on equity because the return on equity can be significantly increased by adding more debt to a company's balance sheet. Adding more debt to a company can inflate profits but comes at the price of a greater risk of bankruptcy.
Measuring profitability using the return on assets does not have this problem because to calculate the return on assets the net income plus the interest expense net of income tax savings is divided by the average total assets of the company. Thus, by dividing the net income (adjusted for the affects of debt financing) by the total assets (debt + equity) of the company, it cancels out the positive effects of debt.
The return on assets is great for comparing the profitability of companies with different levels of debt in their capital structures. Generally speaking, a consistent return on assets of about 7% or more is a good indication of a good business with some type of durable competitive advantage. One exception to this rule of thumb is the banking sector where a return on assets of just 2% is considered exceptional.
Return On Equity:
Costco has had a return on equity in the range of 11.8% to 14.4% over the last decade. We believe that the return on equity will continue to be at about 12% the coming years. Return on equity measures a company's performance in financing and using assets to generate earnings. In contrast to the return on assets, the return on equity considers the affect of financing in generating profits. To calculate the return on equity, the net income (minus dividends paid on preferred stock) is divided by the average common shareholder's equity. As a rule of thumb, a consistent return on equity of 15% or more (assuming a reasonable level of debt financing) is an indicator of a good company with some type of durable competitive advantage.
A discounted cash flow analysis revealed a fair value for Costco shares of $59.29/share. We use the percent of revenue method in our discounted cash flow analysis. The model assumes an average weighted cost of capital (OTC:WACC) of 9.5%. Our WACC is calculated using a proprietary formula unique to our firm. An average annualized revenue growth rate of 8.0% is projected over the next 10 years. An average annualized revenue growth rate of 5.0% is assumed for every year thereafter.
Costco appears to be a medium quality company with an overvalued stock price. Based on a fair value of $59.29/share and the Costco closing stock price of $102.02/share (on 02-14-2013) the stock must fall 41.9% to reach fair value.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: Ulfberht Capital is not an investment advisor. This article is not a recommendation to buy or sell securities. Always consult your investment advisor before making any investment decision.