One is currently out of fashion and the other is a golden boy. One is supposedly facing doom from the rise of Amazon and the other supposedly doesn’t face this threat. One trades at 11.6 price to earnings while the other trades at 30 price to earnings. One gives you 2.58 times more earnings off the bat while the other, well, gives you 2.58 times less earnings off the bat. Wal-Mart vs. Costco: which is the better asset to buy?
A friend and I were discussing Costco last night and it piqued enough interest in me to break out a few notes to do a rough, back-of-the-envelope comparison between the two retail giants. My friend likes Costco, but is the current price – $161 a share as of close on December 1, 2015 – rational to buy into the asset? Is the seemingly lofty 30 P/E ratio that is currently attached to Costco worthy or is it an indication of slight over-valuation and risk of P/E compression going into the future?
To get a sense of the two companies, I drew up a quick spreadsheet with the following information:
- Hypothetical $1000 investment
- P/E Ratio
- Earnings Yield
- Net Profit Margin
- Asset Turnover
- Equity Multiplier
- Return on Assets
- Return on Equity
- Return on Capital Employed
- Return on Invested Capital
- 5 Year Analyst Earnings Growth Estimate (averaged down to the nearest whole percentage)
- Current Earnings per Share
- Total Earnings based on a Hypothetical $1000 investment
I’ve thrown in Kroger to compare with Wal-Mart and Costco just to have another retail/grocery giant as a reference point. In case you need to brush up on some of the ratios, there is a legend attached at the end of this post. Here is the spreadsheet:
Wal-Mart vs. Costco
On first glance over these ratios, you notice that Wal-Mart has the largest net profit margin at 3.4%. However, Costco is more efficient at using its assets to generate revenue. Costco also employs more leverage, resulting in a higher Return on Equity ratio. Costco also generates higher Return on Capital Employed. Wal-Mart and Costco share an almost identical Return on Invested Capital figure. Analysts believe Costco will grow earnings much higher over the next 5 years than Wal-Mart.
Also, not shown in the table above is the dividend yield for both companies: Wal-Mart gives you a starting yield of 3.3% while Costco gives you a 1% starting yield.
It should be obvious that the market is more optimistic about Costco’s prospects as an investment. However, is a P/E ratio of 30 justified? Is it a fair deal?
Based on the ratios above, I don’t see much variance in the financial ratios of either company. Therefore, we can then assume that the P/E is almost 2.6 times higher for Costco because of its higher expected earnings growth rate into the future.
There are two old school, super conservative, back of the envelope ways to gauge whether Costco is an ideal buy candidate at this price point, these earnings, and the expected growth rate of 8%.
Graham & Lynch
We could use something Benjamin Graham once recommended, which was that you should never buy a stock that had a P/E ratio that was higher than the sum of the earnings yield and the growth rate. By this definition, 30 P/E is much higher than 11.33 (the sum of 3.33% earnings yield and 8% assumed earning growth rate). For Wal-Mart, the gap is a little closer at 11.64 P/E vs. 9.59 (the sum of 8.59% earnings yield and 1% assumed growth rate).
Instead of Graham’s method, we could try Peter Lynch’s famous Price-Earnings-to-Growth ratio, adjusting for the dividend yield of each company. When it came to the PEG ratio, Lynch advocated for anything that came up below 1. This indicated a likely, screaming value.
Costco turns up a dividend-adjusted PEG ratio of 3.3 (30.05/(8+1)). Wal-Mart gives a PEG ratio of 2.7 (11.64/(1+3.3)).
Well, it appears, neither meets the strict standards of either Benjamin Graham or Peter Lynch – where to from here?
Undervalued? Overvalued? Fair Value?
So we don’t appear any closer to figuring out whether Costco is a good deal at current prices. Since I did say that this was more of a quick, back-of-the-envelope type of exercise – my favorite kind of exercise when it comes to security analysis as I think there is some danger with trying to get too precise with financial figures – here’s my conclusion.
Costco is a great enterprise. Anyone who has shopped at Costco could tell you that it is a fantastic business. This is entirely anecdotal, but I imagine it applies to almost all Costco’s out there: whenever I’ve been in a Costco, it is insane how many people are there buying stuff. It doesn’t take a genius to see it is a great business.
With that said, at a market capitalization of $71.6 billion, Costco is no upstart, spring chicken. Yes, it still has room to expand stores, revenue, and profit, but it’s most likely well past it’s explosive growth days.
Buying ownership at current prices will potentially lead to satisfactory results, based on several assumptions. If the analyst predictions are correct on the 8% earnings growth over the next 5 years, earnings per share should grow to $7.89 by 2020. If the market is still willing to pay 30 price earnings in 2020, the stock price should be $236. That means the price of the share appreciated from $161 today to $236 by 2020. Add in the 1% dividend yield you get to collect along the way, and based on all of these conditions and assumptions, you could potentially expect 9% compound annual growth over the next 5 years.
Of course, these are based on the conditions listed above. There could be a contraction in the price earnings ratio that investors are willing to pay in the future, which would have a detrimental effect on the returns you experience. Alternatively, perhaps investors will clamor to pay in excess of 30 price earnings, in which case your growth rate over the 5 years will increase. Perhaps we hit a recession and a market crash? Or perhaps the bull market continues? The future is highly uncertain.
In conclusion, be wary of crystal balls and attempt to peer into the future with any precision. It is very difficult, if not impossible, to predict with any certainty where the valuation of an asset will be years down the road.
In this scenario, I advise you do take Benjamin Graham’s advice regarding the “fat man test.” Graham noted that you do not need to know the exact weight of a man to know whether he is fat or not. In the same vein, you do not need to know with precision (because you probably can’t) whether or not an asset is a good deal or not, as it should yell at you that it is either extremely cheap or extremely expensive.
To give you an example, it is my opinion that Facebook at its current price and earnings passes the fat man test as extremely expensive. I do not need to know the precise details and projections of Facebook’s financials to come to that conclusion.
So using the concept of the fat man test, I would conclude that Costco, based on the analyst expectations and current price, is slightly over-priced to fair value. Based on the numbers currently available and the aggregate of analysts’ opinion, one should expect satisfactory results even at the seemingly high price earnings ratio, but not over-performance of the market at large.
In my opinion, I find Wal-Mart much more tantalizing in terms of the fat man test as the expectations are so low right now for the company that even a mild out performance over the next several years should potentially see the price earnings ratio expand back into the mid-teens where Wal-Mart typically hangs out. Along with collecting a 3.3% starting dividend yield, for me, there exists a bit more of a margin of safety built into Wal-Mart at these current prices for potential ownership.
Price/Earnings = Stock Price / Earnings per Share
Earnings Yield = Earnings per Share / Stock Price
Net Profit Margin = Net Income / Revenue
Asset Turnover = Revenue / Total Assets
Equity Multiplier = Total Assets / Shareholder’s Equity
Return on Assets = Net Profit Margin x Asset Turnover
Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier
Return on Capital Employed = Earnings before Interest & Tax / (Total Assets – Current Liabilities)
Return on Invested Capital = (Net Income – Dividends) / Total Capital
Dividend Adjusted Price-Earnings-to-Growth = (Stock Price / Earnings per Share) / (Assumed Growth Rate + Dividend Yield)