Costco's Rating Downgrade Amid High Valuation Despite Excellent Business Model

Costco Wholesale Corporation, recognized by its ticker symbol COST on NASDAQ, presents a curious case in the stock market. It's a much-favored stock among value investors but is also one of the more expensive options compared to other non-tech mega-cap stocks. With trading multiples similar to high-growth AI firms, COST's valuation seems steep with 46 times forward earnings, 15 times book value, and 30 times cash flow.

The company's retail model is commendable, with only a few competitors in its league. Costco maintains customer loyalty through its membership structure and has a complex supply chain that is difficult to imitate, conferring the stock a degree of safety. Nevertheless, these merits seem to be overshadowed by the stock's high purchase price, which rarely dips into a more reasonable range—an issue highlighted even during the March 2020 market downturn.

Despite its stock price increasing over time, the expected growth does not align with current valuations. The expected growth for 2024 is a modest 4.5%, suggesting that the stock might be overvalued or just fairly valued at best. Previously, I've found COST's competitive position a strong enough factor to consider it a buy, even when trading at 36 times earnings. Today, however, the stock's valuation surpasses those of leading growth companies like NVIDIA Corporation, prompting a downgrade from buy to hold.

Investor Confidence

Costco has attracted a remarkable shareholder base including reputable superinvestors like Charlie Munger and Warren Buffett, who have sold their positions in the past. Such backing has forged Costco's reputation as a 'safe' investment.

Market Dominance

Costco enjoys a dominant stance in the discount retail market, holding significant shares and leveraging its exclusive product lines such as the Kirkland Brand to fend off competition from similar wholesale entities. Moreover, the company's members receive rewards and perks, which keep them engaged and loyal.

Financial Performance

Costco's profitability metrics appear promising, with strong returns on equity and capital, yet its growth figures do not support the current earnings multiple. Reviewing the profitability against growth data, the financials do not seem to justify its lofty valuation.

Stock Valuation

Given Costco's trailing twelve-month (TTM) numbers and growth history, current earnings multiples are difficult to justify. Even discounted cash flow (DCF) models suggest that the stock is priced higher than it should be unless a major growth catalyst comes into play, which looks unlikely. As such, despite the perceived quality of COST stocks underpinning long holding periods, I would recommend against investing additional capital at this time.

Costco, valuation, downgrade