Looking At Costco's Valuation 'Carry Through' Effect

| About: Costco Wholesale (COST)


Costco the business has performed quite well over the last decade.

Likewise an investment in the company has done well, benefiting from solid growth and a higher valuation.

This article looks at what the future may hold, considering the valuation “carry through effect.”.

When I think about Costco (NASDAQ:COST), I remember a 2011 transcript from "A Morning With Charlie" - a Q&A session with Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) Vice-Chairman Charlie Munger. Someone asked him what his favorite company was outside of Berkshire. His answer was immediate: Costco. He went on to detail his admiration for the CEO, the low pricing strategy and its "moral duty" to the customer.

The only issue was that the world had "figured out" what a great company it was and at the time shares were trading around 25 times earnings. So you had to be comfortable with the valuation.

Interestingly, so far it's worked out quite well for investors. Going back to 2003, even with shares trading with a mid-20's P/E ratio, investors have now seen total returns on the magnitude of 13% per annum. And since 2011 when the valuation was a bit higher, investors have done even better. So far you would have observed a very strong business with an expanding rather than contracting earnings multiple. The "premium" required has thus far been worth it.

Yet this doesn't mean that this always has to be the case. It's conceivable that even with the business doing quite well, the valuation could come down for any number of reasons. That's what I'd like to explore today.

First, let's get a more detailed look Costco's business and investment history:

The above calculations are from 2005 through the end of 2015. As you can see, Costco had a number of factors working in its favor.

The revenue growth during this time was quite impressive - moving from $53 billion all the way up to $116 billion, as the store count increased by about 60%. The annual rate of revenue growth came in at about 8%.

Next you have the profit margin, which tends to be quite low for these types of retail stores. Still, an improvement from 1.9% to 2% lead to company-wide earnings growth that slightly outpaced overall revenue growth.

From there the company decreased its share count by just under 1% per year, resulting in earnings-per-share growth of about 10% annually. If the valuation multiple remained the same at the beginning and end of the period, the share price growth would be the same as the EPS growth. Yet this was not the case with Costco.

At the beginning of the period shares were trading hands around 24 times earnings. By the end of the period this number was closer to 30. As a result, the share price grew by 12.6% per year.

Finally, if you add in the dividend component, which was initiated in 2004, you come to a total return of nearly 14% per annum. Note that the regular dividend hasn't been substantial, but a pair of special payouts certainly have been. As a point of reference that's the sort of thing that would turn a $10,000 starting investment into $37,000 after a decade.

Costco's robust revenue growth was further bolstered by an increase in the profit margin, a decrease in the share count, its dividend payment and a significant uptick in the valuation investors were willing to pay. These factors all worked in tandem to provide past investors with solid returns. Moving forward, some of these items could be potential headwinds instead of tailwinds as was the case in the past.

Let's look at a hypothetical situation to get a better feel for what I mean:

The middle column presents the exact same information that was detailed above for reference. The right-hand column provides a hypothetical scenario over the coming decade. It should be underscored that this is simply a baseline and ought to be adjusted according to your own expectations.

For the top-line growth I have seen estimates that indicate the company can continue to grow at its previous pace, but I think a bit of caution could be warranted. You have a company that now sells twice as much stuff, so it's harder to grow off of a higher base. Moreover, even if Costco opened the same amount of stores in the coming ten years as it did in the past, this would still represent a slower overall growth rate. So I used 7% - below what was previously accomplished, but still quite solid.

In the retail business, especially one aimed at lowering consumer cost, it's hard to demand substantial margins. As such, this was kept at 2% as well - indicating company-wide earnings growth that is on par with revenue growth.

Lately the share count has been stagnant and with a higher valuation it becomes more difficult to retire shares. Put together these items indicate earnings-per-share growth of about 7.5% over the next decade. That's a reasonably solid mark. It's below what the company was able to achieve in the past, but it still represents a sizable uptick in the underlying earnings claim for today's shareholder.

If the valuation multiple were to remain the same during the period, you would see share price growth that is in line with EPS growth. In order for the future share price growth to be on par with the 12.6% annual pace set in the past, shares of Costco would need to trade at 47 times earnings or thereabouts. This is within the realm of possibility, but not altogether likely in my view. A lower, rather than equal or higher, future valuation multiple would be a more prudent assumption.

Costco's historical average earnings multiple has been in the low-20's for the past couple of decades. Using a future multiple of 24 results in the expectation of just over 5% yearly share price growth.

Finally, we can add in the dividend. With a low comparative payout ratio and high valuation today's investor does not stand to receive large amounts of cash flow in comparison to your alternatives. With the dividend added, you might suspect that future returns could be around 6% or so. As a point of reference, that's the sort of thing that would turn a $10,000 starting investment into $18,000 or so. That's reasonable, but also a far cry (basically half) of what the previous long-term investor would have experienced.

Should faster growth formulate or if shares continue to trade at a higher valuation, your anticipated returns would likely be greater than 6%. Alternatively, if the company grows a bit slower or shares trade with a lower multiple the expected return could very well be lower than this benchmark. Depending on your view, the current valuation is more or less reasonable but perhaps not altogether compelling.

In short, Costco has proven itself to be a solid company and appears to have the propensity to continue performing well. Past shareholders experienced very solid gains, but this idea does not simultaneously indicate that a future investor will be rewarded in the same way. This is especially true should the company "falter" and "only" grow by 4% or 5% and trade hands with an earnings multiple in low-20's or even teens. An investment in Costco is an investment in the faith of the business and the expectation that strong growth will materialize. Even so, future returns are apt to be lower than what previous investors experienced, barring some extraordinary circumstances.

Disclosure: I am/we are long BRK.B.

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.