Editor's Choice

The Street Expects Too Much

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

What I've found over the last 20 years of investing is, sometimes you can stumble across a great company, but the stock never becomes a buy because of valuation concerns. It's extremely important that investors understand that the long-term performance of their portfolio will be affected just as much by finding the right stock, as not paying too much for the shares. There seems to be a prevailing belief today that great companies can be bought at any price. This is not the case, and history is rife with examples of companies that performed very well, but their stock price did not because expectations were too high. I believe that is the situation facing Costco (NASDAQ: COST) investors today. The company is performing well, but the current price already reflects high expectations.

Costco's business model is very simple. The company buys in huge quantities, sells these items at razor thin margins, and makes money on membership fees. I've written in the past, that Costco is more than just a warehouse club. The company offers discounts on a range of services from health insurance to buying a car. Some of Costco's services alone could be worth the standard $55 membership fee, and this would make any savings on items in the stores just a bonus.

Some of Costco's major competition are companies like Amazon.com (NASDAQ: AMZN), Wal-Mart (NYSE: WMT), and Target (NYSE: TGT). While each of these competitors offer a slightly different value proposition compared to Costco, they compete directly in the areas of groceries, electronics, clothing, and more.

Amazon is unique among the four companies. Customers can buy virtually anything you can think of through the site and have it delivered to your door. However, Amazon also offers digital sales, and a large catalog of movies and televisions shows that can be streamed instantly. Wal-Mart and Target are more traditional competitors, and each company has expanded their grocery offerings to try and take business from Costco. In addition, the increasing number of Target Greatland and Super Wal-Mart stores is blurring the line between traditional big box retailer and warehouse store. Where Wal-Mart and Target have run into challenges keeping up their same-store sales growth, Costco has been very consistent in reporting above average same-store sales increases.

Looking at Costco's last quarterly earnings, you can see strength in sales across the board. The company's net sales increased 10%, and EPS increased 18.75%. Equally impressive was the company's same-store sales increased 7% overall. With 621 locations worldwide, the company is in the middle of what should be a multi-decade expansion. While these growth numbers are impressive, Costco sacrifices their margins for growth.

Costco's recent operating margin was just 2.75%. Amazon is still expanding, and shows a negative operating margin. However, Amazon's investments today should lead to greater margins tomorrow. For the present, comparisons to Costco are a bit unfair. Wal-Mart and Target are more established retailers, and they reported 5.37% and 7.62% operating margins recently. You can see by this large difference in margins that Costco is willing to do whatever it takes to keep its customers coming back for more. While customers love the store's value, it seems investors are expecting a lot from the company, and they may be disappointed.

Looking at the relative value that Costco sells for, investors certainly have high hopes. When comparing companies, I like to use a method that Peter Lynch talked about. He used a formula that works like an inverted PEG ratio called the PEG+Y. The formula takes a company's yield, adds their expected growth rate, and then divides this total by their P/E ratio. The idea is, investors can compare companies relative values including the benefit of their current yield. With a PEG ratio, the current yield is ignored, which is unfair to dividend payers.

The Amazon comparison is a difficult one, as the company does not pay a dividend and sells for a high valuation. Shares currently trade for over 159 times projected earnings, yet analysts are calling for 32.6% EPS growth in the next few years. Using Lynch's PEG+Y method, Amazon's growth rate of 32.6% is divided by the P/E ratio of 159 to produce a result of 0.21. Unlike the PEG ratio, a low number here is a bad sign. Long story short, Amazon's investors have even higher expectations than Costco's stockholders.

By comparison, Costco scores a 0.60 (1.07% yield + 12.66% growth / 22.83 P/E ratio = 0.60). Using the same calculation, Wal-Mart scores a 0.89 and Target scores a 1.10. Since Lynch was looking for a 1.5 or better, technically none of these companies passes his test. However, the higher the number the better, and Target comes out on top.

When you consider that Target has an expected growth rate that only trails Costco by 1%, yet Target's yield is more than 1% higher, you can see how Target could be a better value. In addition, Costco sells for a forward P/E of 22.83 compared to just 12.75 times projected earnings for Target stock. Given a choice between Costco and Target, Target seems the better choice by far. If both companies meet analysts’ estimates, investors are already paying nearly twice as much for Costco on a relative basis. I'm afraid Costco investors are overestimating their company's potential. Just because the company is a leader, doesn't mean you can ignore the stock's valuation. It's ironic that a company with such deep discounts for customers sells for such a rich valuation.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com and 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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