Why Investors Are Paying a Premium for Costco Stock

Markets Motley Fool

Many investors are avoiding the retailing industry as if it were an out-of-favor strip mall. Wall Street is worried that the latest shopper traffic slowdown is just the beginning of a long, painful period of adjustment while physical stores lose relevance amid a surging digital sales channel. 

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Costco (NASDAQ: COST) stock hasn't been caught up in that pessimism. Yes, shares are just barely in positive territory this year, compared to an 11% gain for the broader market. But the warehouse retailer enjoys a large and, in my view, justified premium over its peers.

The Costco stock premium

Costco is valued at 28 times the past year of earnings. That's well above the broader market's P/E of 24, and its also more expensive than the valuation of Wal-Mart (NYSE: WMT), Target (NYSE: TGT), or Kroger (NYSE: KR)

The same trend is true with respect to sales. Investors are paying 0.59 times revenue for Costco, compared to about 0.5 times for Wal-Mart and Target and less than 0.2 times for Kroger:

Company

Price/Earnings

Price/Sales

Costco

28

0.59

Wal-Mart

19

0.5

Target

13

0.48

Kroger

12

0.17

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Sales and profits

Investors are forking over extra money for this business in part because it is growing so quickly. Comparable-store sales were up 5% in its most recent quarter, while Wal-Mart and Target were stuck at below 2% and Kroger just barely achieved any comps gain. 

That performance gap at existing locations also translates into a brighter picture for the store base. Whereas many retailers are looking at closing underperforming locations, Costco launched 29 new warehouses over the past year.

Its subscription-based business model is another factor that supports Costco's premium valuation. Most of the retailer's earnings are generated through membership sales, not product sales. And because an overwhelming portion of members renew each year, that revenue stream leaves the company far less exposed to shifts in shopping behavior. 

A growing member base helped fee income cross $2.6 billion last year, up from $1.6 billion in 2010. That stability helps explain why Costco's earnings continue trending higher even as peers suffer through wide swings and generally weaker growth.

An extra kicker

Finally, Costco's premium reflects the substantial dividends that the company has paid out. Sure, the stated 1.2% annual yield is far below the 4% you could get with a Target investment or the over 2% paid by Kroger or Wal-Mart. 

Costco pays far higher dividends than its quoted yield implies, though. It recently issued a $7-per-share special dividend, which by itself equated to an almost 4% return. And while management calls these events "special" dividends, they happen with some regularity. 

The warehouse giant issued a $5-per-share bonus to investors two years ago and another $7-per-share dividend in 2012. Altogether, it has sent over $8 billion to its shareholders in special dividends in the past five years.

Will the gap continue?

These operating and financial advantages make Costco a less risky investment than many of its retailing peers, but the retailer still faces threats, including from e-commerce specialists. The good news for investors is that, because subscription fees allow it to keep its gross profit margin consistently low, there's less concern over a pricing war driving profitability far lower.

Instead, the biggest risk to Costco's business is that shoppers will begin concluding that the membership just isn't worth the annual fee. With subscriber rates ticking up to a stellar 90% this past quarter, there's no evidence of that happening today.

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Demitrios Kalogeropoulos owns shares of Costco Wholesale. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.