Better Buy: Wal-Mart Stores Inc. or Costco Wholesale?

By Markets Fool.com

Wal-Mart Stores andCostco Wholesale Corp: these retail behemoths are two of the largest retailers by sales in the U.S.

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After that, however, the similarities may end. Costco tends to target coastal blue states, while Wal-Mart is most popular in the deep-red heartland. Similarly, Costco shoppers tend to be wealthier than the average American while Wal-Mart loyalists hail from the low-to-middle income tax brackets.

Costco derives most of its profit from its membership fees, selling its goods in bulk at near-cost. Wal-Mart uses a more straightforward Everyday Low Prices strategy, and its warehouse business, Sam's Club, has always played second fiddle to Costco.

The two also diverge in their labor policies. At Costco, average wages are over $20 an hour and entry-level employees start at $11.50/hour, well above the minimum wage. Wal-Mart, long known for its anti-union stance and employment violations, stunned the business community recently when it said it would raise wages above minimum wage.

Finally, and most importantly for investors, the stock performances have differed widely in recent years as Costco stock has risen 151% in the last five years, while Wal-Mart is up just 46%. The chart below shows the difference:

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WMT Chart

Wal-Mart vs. Costco Stock Performance, data by YCharts

The disparity shouldn't come as as a surprise. Costco's financial performance, seen in rising profit and same-store sales, has also bested that of Wal-Mart, which has seen growth stagnate at its core superstore format.

Despite Costco's track record against Wal-Mart in recent years, there are several reasons why Wal-Mart stock could now have the edge over Costco. Let's take a closer look at some of them:

1. Valuation
In the midst of Costco stock's 151% spike over the last five years, the stock's valuation has also ballooned. In 2010, it had a P/E of just 20; now it has a P/E of 29. Had the ratio held steady, the stock's growth would have been only about 100% in that time period.

Wal-Mart's shares, meanwhile, are much cheaper than Costco's at a P/E of just 16. That's roughly on par with the S&P 500'shistorical average of 15, and lower than the S&P 500's average today. Wal-Mart's P/E is also significantly lower than those of rivals such as Target. Though Costco's stronger growth merits a higher valuation, its P/E of 29 -- nearly double that of Wal-Mart -- is surprising for a mature company like Costco.

2. Capital Returns
Dividends are often a major reason why investors like blue-chip stocks such as Costco and Wal-Mart. Wal-Mart is a Dividend Aristocrat, having raised its quarterly payout for 40 straight years. It now offers an annual payout of $1.96, good for a 2.4% yield.

Costco, meanwhile, offers just a 0.9% yield. The warehouse retailer has been known to pay a special dividend from time-to-time, though. At the end of 2012 it gave investors a dividend of $7/share due to changing tax rates. More recently, it offered shareholders a $5/share special dividend as a simple form of one-time profit-sharing.

While those special dividends are certainly a boon to investors, Wal-Mart's steady 2.4% yield is perhaps more reliable. Costco does have a slightly lower payout ratio at about 30%, compared to 40% for Wal-Mart.

When it comes to share buybacks, Costco's share count held steady over the last year as management has preferred to return cash through dividends, perhaps due to the high P/E ratio. Meanwhile, Wal-Mart reduced its share count by about 1% last year, helping to nudge earnings per share higher.

3. Margins
Despite Costco's stronger growth, Wal-Mart's profit margin is much better at 4% vs. 2% for Costco. That means Costco needs to add twice the amount of sales that Wal-Mart would need in order to create the same amount of incremental profit. This is a huge advantage for Wal-Mart as long as it can maintain its profit margin, though the recent declines in comparable sales in some quarters have created headwinds for that metric.

Though Costco the company is still firing on all cylinders with 7% same-store sales growth this year and a steady expansion plan, at a P/E of 29, the stock's growth may be tapped out for now. Wal-Mart, meanwhile, is launching a wave of initiatives including raising wages, pushing suppliers to lower prices, and improving its grocery department, which could boost the company's tepid financial performance. Wal-Mart is also making investments in e-commerce and its small-store format, which have shown to be promising growth areas.

Therefore, I'd give Wal-Mart the nod as the better buy. The upside potential for the world's largest retailer is much greater, and investors can collect a 2.4% dividend yield while they wait. Costco, meanwhile, is a great company, but the stock seems overpriced. If Wal-Mart can win back some of those customers lost to Costco and others, its stock should move higher.

The article Better Buy: Wal-Mart Stores Inc. or Costco Wholesale? originally appeared on Fool.com.

Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.