It's Hard Not To Like Costco

Summary

• Costco is trading at around 20% below its high of late 2020.
• The Wall Street consensus is bullish.
• The option-implied outlook is neutral with low volatility.
• The valuation remains quite high, but not enough to overshadow other positives.
• My final rating is bullish.

Bank of America (BAC) just reiterated its buy rating on Costco (NASDAQ:COST), shortly after the company reported earnings on March 4th. The earnings report was mixed, with a beat on non-GAAP EPS and a miss on GAAP EPS. The stock price dropped in the next trading session in response to the earnings, but has largely returned to its level before the announcement. The market was already jittery about COST before the call, as reflected in the falling price YTD. Since closing at $391.77 on 11/30/2020, COST is down about 20% and closed at $311 on 3/8/2021.

I am a fan of Costco as a shopper but I have avoided the stock mainly on the basis of valuation. Even now, the forward P/E is 31.9, which is comparable to tech giants like Microsoft (MSFT) (forward P/E = 31.4) and Alphabet (GOOG) (GOOGL) (forward P/E = 30.4). While this is high (especially from a historical perspective) for a retail chain, e-commerce is a significant and rapidly growing part of Costco’s business. While only 6% of Costco’s total sales in 2020 were online, the growth rate of Costco’s e-commerce is very high. There is also a good argument that Costco can be expected to improve its margins over time, which has the potential to boost EPS.

Price chart and basic statistics for COST (Source: Seeking Alpha)

Even with the price declines since Thanksgiving of 2020, the stock’s historical total returns over extended periods are in line with, or higher than those of the broader discount store sector. Over the past 3 years, COST’s total annualized return is 21.02% vs. 19.20% for the sector, for example.

Trailing total returns for COST vs. Discount Store sector and U.S. stock market (Source: Morningstar)

Wall Street Analyst Outlook

The outlook for COST from Wall Street analysts is bullish, with a consensus 12-month price target of rated analysts equal to $374.59, as calculated by eTrade, which is more than 20% above the current price. Even the lowest price target from among the 19 analysts in eTrade’s cohort has a price target that is 4.4% above the current price. It is worth noting that the consensus 12-month price target is very close to where the stock price peaked in late 2020.

Wall Street analyst consensus rating and 12-month price target for COST (Source: eTrade)

The Wall Street cohort surveyed by Seeking Alpha, with 34 analysts, is much larger than the group of 19 analysts assembled by eTrade. The consensus price target of the 34 analysts is $376.31, 21% above the current price. The uniformity of the outlooks is also notable, with only 1 of the 34 giving the stock a bearish rating.

Wall Street analyst consensus rating and price target for COST (Source: Seeking Alpha)

Outlook From the Options Market

Another way to generate an outlook for a stock is to analyze the prices at which options on the stock are trading. The market prices of options provide information about traders’ consensus outlook on the probability of the price going above a certain level (call options) or below a certain level (put options) over some period of time (from today until the expiration date of the options).

By aggregating market prices of call and put options with the same expiration date but different payouts (different strike prices), it is possible to employ a mathematical model to calculate the implied probability of all possible future returns. This strategy is well-established in institutional finance. For some background, see the Minneapolis Fed’s web pages on their implementation. For a review of the literature on how options prices are useful in generating outlooks in general and with examples using my version of this approach, see this presentation.

The option-implied probabilities of expected price returns are charted as a probability distribution. When I chart the option-implied probability distribution for future return, I rotate the negative side of the distribution about the vertical axis so that the relative probabilities of positive and negative returns are easier to see.

The price outlooks derived from options prices are probabilistic rather than a specific forecast of the future price. The options prices may indicate increased or decreased likelihood of gains or losses and this provides insight into the prevailing beliefs of those buying and selling options.

I have analyzed options expiring on January 21, 2022, to generate an option-implied price return outlook from now until that date.

Option-implied price return probabilities for COST from now until January 21, 2022 (Source: author’s calculations using options quotes from eTrade)

The option-implied price return outlook to January 21, 2022, is neutral, with almost identical probabilities of positive and negative returns of the same magnitude (the solid blue line lies almost on top of the dashed red line). The single most-probable price return between now and January 21, 2022, is 1.9%, but the probability peak is small enough to be in the noise. The annualized volatility derived from this distribution is 27%, which is quite low for an individual stock.

On the basis of the option-implied probability distribution, there is an even 50% chance of price gains and 50% chance of losses between now and January 21, 2022. The 20^th percentile of price return from now until January 21, 2022, is -19%. This means that there is a 1-in-5 chance of having price returns as bad or worse than -19% over this period.

Summary

Costco’s share price is down about 20% since its November 2020 peak, but the Wall Street analysts are sticking by their bullish outlooks. The stock’s valuation looks more attractive following the decline over recent months but remains quite high: the Seeking Alpha quantitative value grade is a D. The option-implied outlook is almost perfectly neutral and the implied volatility is low. What this means is that the options market is pricing in a low potential for bad news. The analyst consensus price outlook is for a 20% price gain. An expected 20% price gain with a 20^th percentile return of -19% would be an attractive bet. My final rating is bullish.

Analyst’s Disclosure: I am/we are 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.