Costco Is Too Expensive

| About: Costco Wholesale (COST)

By Matt Doiron

With its stock price rising about in line with the increase in the S&P 500 index year to date, Costco (NASDAQ:COST) has retained a premium valuation relative to many other discount retailers. At its current market capitalization of $52 billion, the trailing P/E comes out to 26; even if we look ahead to the forward fiscal year, where sell-side analysts expect an increase in earnings per share, the stock is valued at 24 times consensus earnings.

Costco's most recent quarterly report details results from the fiscal quarter ending in mid May 2013, the third quarter of the retailer's fiscal year. Revenue grew by 8% compared to the same period in the previous fiscal year, including a 5% increase in comparable store sales as well as increased sales stemming from the opening of new locations. Because of improvements in the company's net margins, Costco's earnings outpaced growth in revenue and net income year to data was up by nearly 30% from its levels a year ago.

Cash flow from operations has also been on the rise. The company used its excess free cash flow to help finance a special dividend in late 2012 before an increase in tax rates, but would now seem to be generating between $1.5 billion and $2 billion in cash after investing activities on an annual basis. The company's recent commitment to returning cash to shareholders suggest that much of this cash may be used on future dividend increases.

We track quarterly 13F filings from hundreds of hedge funds and other notable investors. As part of our research on 13Fs, we have found that the most popular small cap stocks among hedge funds earn an average excess return of 18 percentage points per year (learn more about our small cap strategy). Insider Monkey's own portfolio based on this strategy outperformed the S&P index by 33 percentage points in the last 11 months. This database is also useful for researching hedge fund positions in individual stocks. Renaissance Technologies, founded by billionaire Jim Simons, reported a position of 1.1 million shares in Costco as of the end of March (see Renaissance's stock picks). Warren Buffett's Berkshire Hathaway was another major shareholder (find Buffett's favorite stocks).

The closest peers for Costco are Wal-Mart (NYSE:WMT) and Target (NYSE:TGT). These two stocks each trade at 13 times forward earnings estimates. In Target's case, that figure reflects expectations from Wall Street analysts that the company will recover from its recent struggles (earnings were down nearly 30% last quarter compared to a year ago). We'd be cautious of placing too much faith in these projections, however. Wal-Mart got off to a poor start to the quarter, according to leaks from company memos, but apparently it managed to salvage at least stable performance. According to its 10-Q, revenue and profits each inched up 1% (we'd note that Buffett, in addition to Costco, also has a large position in Wal-Mart). Of course, both of these retailers as well as Costco offer moderately low beta statistics, in the 0.3-0.5 range.

We can also compare Costco to dollar stores including Dollar General (NYSE:DG) and Dollar Tree (NASDAQ:DLTR). These two stocks are even more defensive than the big-box stores, with betas closer to 0.1. Both Dollar General and Dollar Tree delivered revenue growth in the upper single digits in the first quarter of the FY (the quarter ending in early May) versus a year earlier. Dollar Tree managed to capitalize on this good revenue performance, with earnings up over 10%, though that stock carries trailing and forward P/Es of 19 and 16 respectively. This places it at a premium to the three companies we'd discussed earlier. As for Dollar General, the larger of these two by market cap, that retailer has had more trouble with operations leading to a decline in margin. Its forward P/E is 15.

Therefore Costco is considerably more expensive in forward earnings than its peers, with nearly double the P/E multiple offered by Wal-Mart or Target. Recent performance has been good, but that pricing still seems aggressive and so we would advise interested investors to consider other discount retailers instead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article is written by Insider Monkey's writer, Matt Doiron, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.