4 Tests to See if This Stock Is a Good Value

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

While part of stock picking can be about gut feelings and intuition, sometimes knowing if a stock is a good buy has to do with how the company stacks up to its competition. I’ve been worried about Costco’s (NASDAQ: COST) value for a while now. To be blunt, Costco investors have been paying a pretty penny for the company’s predictable growth. The question is, are investors expecting too much, or are they paying a reasonable price for a great business?

Where Do They Fit?

One of the key questions that we have to answer first is, who are Costco’s competitors? After all, in order to know how well the company is doing compared to others, we have to establish who those companies are.

I would argue that Costco’s three major competitors are Wal-Mart (NYSE: WMT), Target (NYSE: TGT), and Kroger (NYSE: KR). Costco is well known as a warehouse club that sells grocery and household goods at deep discounts. Wal-Mart gets about 55% of its revenue from grocery items, and the vast majority of the company’s stores offer either full or expanded grocery selections. In addition, Wal-Mart’s own Sam’s Club is a key competitor to Costco.

Where Target is concerned, the company has also pushed hard to get into the grocery business. Between Target and SuperTarget locations, the company offers at least an expanded grocery selection at about 75% of its stores. Kroger of course is one of the largest grocery chains in the country.

Yield And Growth Comparisons

The two ways investors make money on a stock are through dividends and share price appreciation. Share prices largely follow the direction of earnings growth, so companies with premium earnings growth usually command a premium, and their share prices benefit.

When it comes to yield, the simple fact is, Costco’s yield is lower than any of their peers. However, we’ll use a weighted average of their yield compared to their peers. Look at the comparison:

Company

Costco

Walmart

Target

Kroger

Yield

1.12%

2.43%

2.07%

1.77%

Weighted Avg.

15.16%

32.88%

28.01%

23.95%

(avg. is the percentage of the total yield of all four companies combined)

As you can see, Costco’s low yield means of these four companies, the company’s yield is just over 15% of the total. When we get to the end of this calculation, the company with the highest percentage will be the winner.

If you are looking for growth, analysts expect better growth from Costco compared to their peers. Let’s see how these numbers compare:

Company

Costco

Walmart

Target

Kroger

EPS Growth

13.47%

9.29%

11.63%

7.3%

Weighted Avg.

32.31%

22.28%

27.90%

17.51%

Looking at this measure, Costco is the clear leader, representing more than 32% of the total growth from these four companies.

2 Direct Comparisons

Whether you agree with comparing yield and EPS growth, there is no question that same-store sales and margins are directly comparable. We will start with same-store sales to see which company is the strongest of the bunch.

Company

Costco

Walmart

Target

Kroger

Same-store sales

5%

-1.4%

-0.60%

3%

Weighted Avg.

62.50%

0%

0%

37.50%

If you are looking for a crushing performance, Costco clearly is the leader in same-store sales. Since both Wal-Mart and Target reported negative numbers, only Costco and Kroger can comprise the total. With Costco taking over 62%, and Kroger only taking 37.5%, there is no question who is the best in this category.

Last but not least, it makes sense to look at Costco’s free cash flow production. To compare the companies, I use core free cash flow compared to each dollar of revenue. Core free cash flow is net income plus depreciation minus capital expenditures. This figure strips out some of the accounting adjustments that aren’t real cash.

Company

Costco

Walmart

Target

Kroger

Free Cash Flow Per Dollar Of Sales

$0.012

$0.03

$0.008

$0.011

Weighted Avg.

19.67%

49.18%

13.11%

18.03%

Since free cash flow can be used for dividends, share repurchases, and acquisitions, it’s extremely important to investors. As you can see, while Costco performs well, Wal-Mart takes this category hands down.

The Verdict

In theory if Costco is equal to its peers, the company should garner 25% of each category for a total of 100%. If the company comes in above 100% it is outperforming its peers, and anything less than 100% is underperformance.

When we add up the totals, Costco scores 129.64%, Wal-Mart comes in at 104.34%, Target scores 69.02%, and Kroger scores a 96.99%. However, we need one final comparison to figure out if the stock is fairly valued. Look at the relative value versus performance, and I’ll tell you what I see:

Company

Costco

Walmart

Target

Kroger

P/E

24.20

14.6

15.8

12.25

P/E Value Versus Lowest

+97.55%

+19.18%

+28.98%

0%

Total Score Versus Lowest

+87.83%

+51.17%

0%

+40.52%

Target appears the worst value, as the company is more expensive than the worst, but ranks lowest in overall performance. Kroger and Wal-Mart seem to offer the best relative values. Each company offers performance that is significantly better than the worst, but their stocks sell for P/E ratios that are either the lowest or second lowest.

Where Costco is concerned, investors appear to be overpaying for their company’s performance. Costco scores about 88% better than the worst, but sells for a P/E ratio over 97% above the worst. You can go with your gut feeling when it comes to Costco, but the numbers don’t lie, and the stock’s performance doesn’t quite justify the price.

Costco's low prices haven't just benefited customers -- shareholders have walloped the market, returning 11,000% over the past two decades. However, with prices near all-time highs, is the ride over for Costco investors? To answer that and more, The Motley Fool's compiled a premium research report with in-depth analysis on Costco. Simply click here now to gain instant access to this valuable investor's resource.


Chad Henage owns shares of Target. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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