Costco: Does The Valuation Warrant A Buy?

| About: Costco Wholesale (COST)

Shares of Costco Wholesale Corporation (NASDAQ:COST) have returned 17.5% over the past 12 months. At $99.44 per share, the stock is trading fairly close to its 52-week high of $105.97 attained in early December. After a steady 1-year performance, does the stock's valuation still warrant a buy? In this article, I will walk you through my value analysis.

From a relative valuation perspective, Costco's valuation appears to be somewhat rich based on the company's financial performance relative to its peers' (see comparable analysis chart below). Sell-side analysts predict the company's revenue, EBITDA, and EPS to grow at 3-year CAGRs of 8.0%, 11.8%, and 12.6%, respectively, over the current and next 2 fiscal years. Those consensus estimates are considerably higher than the averages of 4.7%, 5.7%, and 12.7%, respectively, for a peer group consisting of Costco's primary competitors. Similarly, Costco's EBITDA margin is forecasted to expand by 0.4% over the same period, almost doubling the peer average at 0.2%. However, the company has a weaker profitability performance as most of its margin and capital return measures are markedly below the par. Costco carries a lower level of debt as reflected by its below-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Costco's trailing free cash flow margin is fairly in line with the peer average. Due to the lower leverage, the company was able to maintain a high interest coverage ratio. Both the firm's current and quick ratios are comparable to the group averages, reflecting a healthy corporate balance sheet.

To summarize the financial comparisons, Costco's superior growth prospects and solid liquidity position should support a premium stock valuation relative to the peer-average level. However, given the company's relatively mediocre margin performance, I would not expect the valuation premium to be significant. Nevertheless, the current stock valuations at 9.4x forward EV/EBITDA (next 12 months) and 21.6x forward P/E represent an average valuation premium of 55.1% over the peer-average trading multiples, and the stock's PEG ratio at 1.7x is also 34.8% over the peer average of just 1.3x (see comparable analysis chart above), suggesting that the company's strong growth potential may have completely been factored in the stock price.

To further analyzing the valuation and understand the growth assumptions that are baked into the stock price, I also performed a DCF analysis by incorporating the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2017 (see DCF chart below). Other free cash flow related items such as depreciation, tax expense, capital expenditure, and working capital investment are projected based on their historical level to the revenue as the ratios have been trending quite steadily over time. To be conservative and reasonable, a company-specific risk premium of 5.0% is applied in the cost of equity calculation to account for the financial projection risk and a normalized 10-year risk-free rate is used.

As such, based on a WACC of 8.1% and a terminal growth rate of 2.5%, the model yields a stock value of $106.04. From the sensitivity table, it appears that the current share price at $99.44 implies a 2.0% terminal growth rate based on the 8.1% WACC, which appears to be fair and thus suggest a reasonable stock valuation.

The same conclusion can also be drawn from a historical valuation standpoint. Costco's trailing P/E multiple of 24.2x is currently trading in line with its 10-year historical average at 23.2x (see chart below). The comparison suggests that the stock is trading at a reasonable valuation provided that 1) Costco's capital return metrics including ROA, ROIC, and ROE have improved markedly over the past 10 years; 2) the company was able to maintain steady profitability margins over the period; 3) the efficiency indicators such as asset turnover and inventory turnover have also been maintained at a steady level; and 4) Costco's revenue, EBITDA, and EPS growth rates are expected to be in line with the historical averages (see charts below).

In conclusion, despite the fact that Costco's valuation has likely reflected the company's superior growth prospects, I believe the company's ability to sustain a steady growth and profitability performance may continue to support the stock's gradual price appreciation. As such, I would recommend establishing a long position in the stock by selling out-of-money put options to either earn a premium or take the opportunity to invest at a lower valuation level.

The comparable analysis and DCF charts are created by author, other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts are sourced from Capital IQ unless specified.

Disclosure: I am long COST. 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.

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