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Costco has important cost advantages. This is proven by the fact that it enjoys a high return on equity (23%), despite the fact that it charges low prices that result in gross margins well below that of other retailers. Its gross profit margin is 15%.
Costco can charge less while still making ample profits. Conventional wisdom would suggest that Costco attempt to increase its gross margins. But Costco expressly chooses to focus on lowering costs and passing the savings along to customers.
Costco is a very well-managed company and has the lowest cost structure of any major retailer. This gives it significant advantages. It is a virtual certainty that Costco will continue to grow and prosper over the years.
It likely could easily add stores in any of the international countries where it is already operating. And there are many developed countries of the world that it could enter. Unfortunately, these advantages tend to be reflected in its stock price and p/e ratio and this continues to be the case at this time.
The major risk to investors is that the high p/e ratio will decline. The market has recently become concerned about the competitive threat from Amazon (AMZN) and its offer to purchase Whole Foods (WFM).
Based on my analysis, Costco’s trailing p/e ratio is 27.6, while its price to book ratio is 6.8. Its dividend yield is low, despite recent increases. This is partly due to its relatively low earnings payout ratio but mostly to its high valuation in relation to earnings. (This dividend ratio excludes occasional large special dividends.)
The ROE (return on book equity) is very strong at 23%. It is clearly a very high-quality company. Its price does not seem compelling but the p/e ratio has come down from the previous level of over 30.
Costco is a great company that almost always seems to trade at a high P/E level. The recent dip is an opportunity to begin to establish or re-establish a position. Be prepared to add to the position on any further material dip.
Shawn Allen is contributing editor of Internet Wealth Builder and The Income Investor.
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